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13-1
Profitability Profitability Analysis of Analysis of
Strategic Business Strategic Business SegmentsSegments
Profitability Profitability Analysis of Analysis of
Strategic Business Strategic Business SegmentsSegments
CChaptehapterr
1313
Prepared by Douglas Cloud
Pepperdine University
Prepared by Douglas Cloud
Pepperdine University
13-2
1. Recognize a strategic business segment.2. Discuss centralized and decentralized
organization structures.3. Understand the development and use of segment
reports.4. Evaluate transfer pricing alternatives, including
international transfers.5. Discuss the issues that cause difficulty in
evaluating decentralized operations.
ObjectivesObjectivesObjectivesObjectives
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
13-3
6. Calculate, explain, and compare return on investment, residual income and economic value-added residual income measures for divisional performance
7. Understand the concept of performance measurement when financial and nonfinancial concepts are integrated.
ObjectivesObjectivesObjectivesObjectives
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Strategic Business SegmentStrategic Business Segment
A strategic business segment is generally one that has its own mission and set of goals to be achieved.
The mission of the segment influences the decisions that its top managers make in both short-run and long-run situations.
13-5
DecentralizationDecentralizationDecentralizationDecentralization
Decentralization is the delegation of decision-making authority to successively lower management levels in an organization.
The lower in the organization that authority is delegated, the greater the decentralization.
The lower in the organization that authority is delegated, the greater the decentralization.
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DecentralizationDecentralizationDecentralizationDecentralization
Firsthand decision making Timely decisions Specialization Motivation Focus Frees up higher level management’s time
The advantages of decentralization include:
The disadvantages of decentralization include:
Compatible performance measurements
Suboptimization Duplication Lack of competent personnel
DecentralizationDecentralizationDecentralizationDecentralization
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CentralizationCentralizationCentralizationCentralization
Centralization exists when top
management has a wide span of
control, including direct control over all major functions of an organization.
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CentralizationCentralizationCentralizationCentralization
Economies of scale Sophistication of applications Improved control
The advantages of centralization include:
13-10
Span of control Complexity Diseconomies of scale
The disadvantages of centralization include:
CentralizationCentralizationCentralizationCentralization
13-11
Organization Chart with DecentralizationOrganization Chart with Decentralization
ManagerManagerPlant 2Plant 2
DivisionDivisionControllerController
President
Executive Vice PresidentExecutive Vice President
V. P.Division A
V. P.Division B
Corporate Controller
Marketing V. P.
Other Corporate
Staff
OtherOtherStaffStaff
Production and Service Departments Area Sales Representatives
ManagerManagerPlant 1Plant 1
MarketingMarketingManagerManager
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Segment Reports are income statements for a portions or
segments of a business.
Segment Reports are income statements for a portions or
segments of a business.
Segment ReportingSegment ReportingSegment ReportingSegment Reporting
They are used were companies have distinct divisions of product
lines, geographic territories, or organization units.
They are used were companies have distinct divisions of product
lines, geographic territories, or organization units.
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Segment ReportingSegment ReportingSegment ReportingSegment Reporting
Three steps basic to the preparation of all segment reports:
1. Identification of the segments
2. Assignment of direct costs to the segments
3. Allocation of indirect costs to the segments
13-14
Segment ReportingSegment ReportingSegment ReportingSegment ReportingIn segment reports, costs
are recorded in four categories.
In segment reports, costs are recorded in four
categories.
Variable costsDirect fixed costsAllocated common costsUnallocated common costs
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Multi-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment Reports
Sales $100,000 $200,000 $300,000Less variable costs -55,000 -95,000 -150,000Contribution margin $ 45,000 $105,000 $150,000Less direct fixed costs -20,000 -60,000 -80,000Division margin $ 25,000 $ 45,000 $ 70,000Less allocated common costs -10,000 -25,000 -35,000Division income $ 15,000 $ 20,000 $ 30,000Less unallocated common costs -12,000Net income $ 23,000
First Level
National Accounts
Regional Accounts
Company Total
Segments (Divisions)
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Multi-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment Reports
Sales $30,000 $70,000 $100,000Less variable costs -15,000 -40,000 -55,000Contribution margin $15,000 $30,000 $ 45,000Less direct fixed costs -9,000 -6,000 -15,000Product margin $ 6,000 $24,000 $ 30,000Less allocated division costs -5,000 -5,000 -10,000Product income $ 1,000 $19,000 $ 20,000Less unallocated common costs -5,000National Accounts Division income $ 15,000
Second Level
Fiber Optic
Twisted Pair
National Division
Total
Segments (Products)
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Multi-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment Reports
Sales $30,000 $70,000 $100,000Less variable costs -15,000 -40,000 -55,000Contribution margin $15,000 $30,000 $ 45,000Less direct fixed costs -9,000 -6,000 -15,000Product margin $ 6,000 $24,000 $ 30,000Less allocated division costs -5,000 -5,000 -10,000Product income $ 1,000 $19,000 $ 20,000Less unallocated common costs -5,000National Accounts Division income $ 15,000
Second Level
Fiber Optic
Twisted Pair
National Division
Total
Segments (Products)
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Multi-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment Reports
Sales $20,000 $10,000 $30,000Less variable costs -11,000 -4,000 -15,000Contribution margin $ 9,000 $ 6,000 $15,000Less direct fixed costs -3,000 -4,000 -7,000Territory margin $ 6,000 $ 2,000 $ 8,000Less allocated division costs -2,000 -3,000 -5,000Territory income $ 4,000 -$ 1,000 $ 3,000Less unallocated common costs -2,000Fiber Optic income $ 1,000
Third Level
Atlantic Pacific
Fiber Optic Total
Segments (Territories)
13-19
Direct Versus CommonDirect Versus CommonSegment CostsSegment Costs
Direct Versus CommonDirect Versus CommonSegment CostsSegment Costs
The segment margin represents the amount
that a segment contributes toward the common costs of the
organization and toward profits.
The segment margin represents the amount
that a segment contributes toward the common costs of the
organization and toward profits.
Direct segment costs are costs that would not be incurred if the
segment being evaluated were to be
discontinued.
Direct segment costs are costs that would not be incurred if the
segment being evaluated were to be
discontinued.
Common segment costs are related to
more than one segment and are not
directly traceable to a particular segment.
Common segment costs are related to
more than one segment and are not
directly traceable to a particular segment.
13-20
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
A transfer price is the internal value assigned a product or service that one division provides to another.
Transfer pricing transactions normally occur between profit or investment centers.
The objective of transfer pricing is to transmit financial data between departments or divisions of a company.
Transfer pricing systems are normally used in decentralized operations to determine whether organizational objectives are being achieved in each division.
13-21
OmniTech, Inc. has five divisions, some of which transfer products and
product components to other OmniTech divisions. The BioTech
Division manufactures two products, Alpha and Beta. Alpha is sold externally for $50 per unit, and Beta is transferred to the GenTech
Division for $60 per unit.
OmniTech, Inc. has five divisions, some of which transfer products and
product components to other OmniTech divisions. The BioTech
Division manufactures two products, Alpha and Beta. Alpha is sold externally for $50 per unit, and Beta is transferred to the GenTech
Division for $60 per unit.
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
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Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
The costs associated with the two products are shown below:
Product Alpha Beta
Variable costs:Direct materials $15 $14Direct labor 5 10Variable manufacturing overhead 5 16Selling 4 0
Fixed costs:Fixed manufacturing overhead 6 15
Total $35 $55
A proposal has been received from an external company to supply the GenTech Division with a
substitute product similar to Beta at a price of $52.
A proposal has been received from an external company to supply the GenTech Division with a
substitute product similar to Beta at a price of $52.
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
Relevant Costs
Buy $52Make:
Direct materials $14Direct labor 10Variable manufacturing overhead 16 -40
Difference favors making $12
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Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
The BioTech Division can sell all the Alpha that it can produce (it is operating at capacity) and there is no external market for Beta. The outlay cost for Beta is $40 ($14 + $10 + $16)
The BioTech Division can sell all the Alpha that it can produce (it is operating at capacity) and there is no external market for Beta. The outlay cost for Beta is $40 ($14 + $10 + $16)
Opportunity Cost
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Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s
opportunity cost is the net benefit forgone.
If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s
opportunity cost is the net benefit forgone.
Opportunity Cost
MakeBuy
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Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s
opportunity cost is the net benefit forgone.
If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s
opportunity cost is the net benefit forgone.
Opportunity Cost
Selling price of Alpha $50Outlay costs of Alpha:
Direct materials $15Direct labor 5Variable manufacturing overhead 5Variable selling 4 -29
Opportunity cost of making Beta $21
Make:Outlay costs of Beta $40Opportunity cost of Beta 21 $61
Buy: $52The company should buy The company should buy from the outside supplier.from the outside supplier.The company should buy The company should buy from the outside supplier.from the outside supplier.
13-27
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Market Price Variable Costs Variable Costs plus Opportunity
Costs Absorption Cost plus Markup Negotiated Prices Dual Prices
13-28
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Market Price
Product Alpha of the BioTech Division can be sold competitively at $50 per unit or transferred
to a third division, the Quantum Division for additional processing. The BioTech Division will
never sell Alpha for less than $50, and the Quantum Division will never pay more than $50
for it. However, because variable selling expenses of $4 per unit can be eliminated in
interdepartment transfers, the price probably will be between $46 and $50.
13-29
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Variable Costs
If Beta could be sold externally for $60, the BioTech Division would not want to transfer Beta
to GenTech Division for a $40 transfer price based on the following variable costs:
Direct materials $14Direct labor 10Variable manufacturing overhead 16Total variable costs $40
13-30
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Variable Costs
The BioTech Division would much rather sell outside the company for $60, which covers
variable costs and provide for a profit contribution margin of $20.
Selling price of Beta $60Variable costs -40Contribution margin $20
13-31
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Variable Costs Plus Opportunity Costs
If the BioTech Division had excess capacity, the transfer price of Beta would be set at
Beta’s variable costs of $40 per unit.
If BioTech Division cannot sell Beta externally, but can sell all the Alpha it can produce, and it is
operating at capacity, the transfer price per unit would be set at $61, the sum of Beta’s variable and
opportunity cost ($40 + $21).
If BioTech Division cannot sell Beta externally, but can sell all the Alpha it can produce, and it is
operating at capacity, the transfer price per unit would be set at $61, the sum of Beta’s variable and
opportunity cost ($40 + $21).
13-32
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Absorption Cost Plus Markup
Absorption cost plus markup provides the supplying division with a contribution toward
unallocated costs. In “cost-plus” transfer pricing, “cost” should be defined as standard
cost rather than as actual cost.
13-33
Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Negotiated Price
Negotiated transfer prices are used when the
supplying and buying divisions independently
agree on a price. Negotiated transfer prices are believed to preserve
divisional autonomy.
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Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price
Dual Prices
Dual prices exists when a company allows a difference in the
supplier’s and receiver’s transfer prices for the same product.
Dual prices exists when a company allows a difference in the
supplier’s and receiver’s transfer prices for the same product.
13-35
SuboptimizationSuboptimizationSuboptimizationSuboptimization
Suboptimization is a transfer pricing problem that exists when divisions, acting in their own best interest, set
transfer prices or make decisions based on transfer prices that are not
in the best interest of the organization as a whole
13-36
SuboptimizationSuboptimizationSuboptimizationSuboptimization
A potential transfer pricing problem exists when divisions exchange goods or services
when there is no established market. In the interest of maintaining a strong profit center philosophy, top management may decide to suboptimize by allowing profit centers to profit services of themselves.
13-37
International Transfer PricingInternational Transfer PricingInternational Transfer PricingInternational Transfer Pricing
Using Transfer Price Based onVariable Cost Full Cost Market Price (000’s) (000’s) (000’s)
Taxable income of the MercedesDivision, excluding the transfer $200,000 $200,000 $200,000
Cost of emission components toMercedes Division
Variable cost ($20 x 300,000) -6,000Full cost ($25 x 300,000) -7,500Market price ($40 x 300,000) -12,000
Taxable income $194,000 $192,500 $188,000Mercedes Division income taxes
(50%) $97,000 $96,250 $94,000ContinuedContinuedContinuedContinued
13-38
International Transfer PricingInternational Transfer PricingInternational Transfer PricingInternational Transfer Pricing
Using Transfer Price Based onVariable Cost Full Cost Market Price (000’s) (000’s) (000’s)
Taxable income of the ChryslerDivision, excluding the transfer $200,000 $200,000 $200,000
Cost of emission components toMercedes Division
Variable cost ($20 x 300,000) 6,000Full cost ($25 x 300,000) 7,500Market price ($40 x 300,000) 12,000
Taxable income $206,000 $207,500 $212,000Chrysler Division Income Taxes
(35%) $72,100 $72,625 $74,200ContinuedContinuedContinuedContinued
13-39
International Transfer PricingInternational Transfer PricingInternational Transfer PricingInternational Transfer Pricing
Using Transfer Price Based onVariable Cost Full Cost Market Price (000’s) (000’s) (000’s)
Total Daimler-Chrysler Income Taxes
($97,000 + $72,100) $169,100
($96,250 + $72,625) $168,875
($94,000 + $74,200) $168,200
13-40
Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)
Investment center income Investment center asset base
ROI =
orROI = Investment turnover x Return-on-sales ratio
13-41
Investment Turnover =Sales
Investment center asset base
Return-on-sales ratio =
Investment center income
Sales
Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)
Investment center income Investment center asset baseROI =
Sales Investment center income Investment center Sales asset base
xROI =
Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)
13-43
North American SteelNorth American Steel
PERFORMANCE MEASURESInvestment Return-on-Sales Turnover Ratio ROI Operating units:
Maine Division 1.50 0.12 0.18Alberta Division 2.00 0.12 0.24Missouri Division 0.67 0.33 0.22Tijuana Division 1.50 0.18 0.27
Company performance criteria:Projected minimums 1.20 0.15 0.18
x =
13-44
Maine Division
Sales Investment center income Investment center Sales asset base
xROI =
$1,600,000 $160,000
$800,000 $1,600,000ROI = x
ROI = 0.20 x 20 percent
North American SteelNorth American Steel
13-45
Residual IncomeResidual IncomeResidual IncomeResidual Income
Division income
Less minimum return (12%)
Equals residual income
$2,000,000
-1,800,000
$ 200,000
$15,000,000 x 0.12Minimum rate of return set by management
13-46
The primary disadvantage of the residual income method
is that it measures performance in dollars. It cannot be used to compare
the performance of divisions of different sizes
Residual IncomeResidual IncomeResidual IncomeResidual Income
13-47
A firm has a cost of capital of 10 percent, $1,800,000 in current
liabilities and a 30 percent tax rate.
Division income after taxes ($2,000,000 x 0.70) $1,400,000Cost of capital employed ($15,000,000 - $1,800,000) x 0.10 -1,320,000Economic value-added residual income $ 80,000
Economic Value AddedEconomic Value AddedEconomic Value AddedEconomic Value Added
13-48
Why Not Just Use Financial Measures?Why Not Just Use
Financial Measures?1. There is no single financial measure that
captures all performance aspects of an organization.
2. Financial measures have reporting time lags that may hinder timely decision making.
3. The financial measures may not accurately capture information needed for current decision making.
13-49
What is the Balanced Scorecard?What is the Balanced Scorecard?What is the Balanced Scorecard?What is the Balanced Scorecard?
It is a performance measurement system that includes financial
and operational measures which are
related to the organizational goals.
It is a performance measurement system that includes financial
and operational measures which are
related to the organizational goals.
Generally it relates resulting performance to the reward system
within each organizational unit.
Generally it relates resulting performance to the reward system
within each organizational unit.
13-50
• Financial Perspective
• Customer Perspective
• Internal Perspective
• Innovation and Learning Perspective
The most commonly used key performance indicators found in a survey are--
Balanced Scorecard Linked to Balanced Scorecard Linked to Organizational PerformanceOrganizational Performance
Balanced Scorecard Linked to Balanced Scorecard Linked to Organizational PerformanceOrganizational Performance
13-51
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
Standard January February
Key financial indicatorsCash flow $25,000 -$4,000 $21,000ROI 0.18 0.22 0.19Economic value-added residual income $130,000 $133,000 $123,000Sales $4,400,000 $4,494,000 $4,342,000
ContinuedContinuedContinuedContinued
13-52
Standard January February
Key financial indicatorsAverage customer per hour 75 80 71Number of customer com- plaints per month 22 21 17Number of sales returns per month 10 8 5
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
ContinuedContinuedContinuedContinued
13-53
Standard January February
Key operating indicatorsBagels sold/produced ratio per day 0.96 0.93 0.91Daily units lost (burnt, dropped, etc.) 25 32 34Employee turnover per
month 0.10 0.07 0.00
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
ContinuedContinuedContinuedContinued
13-54
Standard January February
Key growth and innovation indicatorsNew products introduced during month 1 1 0Products discontinued during month 1 1 1Number of sales promotions 3 3 2Special offers, discounts, etc. 4 5 3
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February
13-55
This electronic presentation was
prepared by Douglas Cloud,
Professor of Accounting, Pepperdine University
13-56
CChapter
1313
The The EndEndThe The EndEnd
13-57