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Segmented Reporting,Investment Center Evaluation

Chapter 10 HM

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1. How & Why adopting standard costing systems

2. State the purpose of a standard cost sheet.3. Describe basic concepts of variance

analysis4. Compute materials & labor variances5. Calculate variable & fixed overhead

variances.6. Prepare journal entries for variances

Last Meeting Review

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Fixed Overhead VariancesTotal FO Variances = Actual Fixed

Overhead – Applied Fixed Overhead

Applied Fixed overhead = (Standard fixed overhead rate) x (Standard hours allowed for actual production)

Budgeted fixed overhead = (Standard fixed overhead rate) x (Practical activity)

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Exercise 9-14

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Exercise 9-14Actual Fixed Overhead = $ 4,140,200Budgeted Fixed Overhead = 288,000 x

$14.4 = $4,147,200Applied Fixed Overhead = 280,000 x

$14.4 = $4,032,000

Fixed Overhead Spending Variance $ (7,000.00) F

Fixed Overhead Volume Variance $ 115,200.00 U

Total Fixec Overhead Variances $ 108,200.00 Underapplied

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1. Explain how & why firms choose to decentralize.

2. Explain the difference between absorption & variable costing, & prepare segmented income statements.

3. Compute & explain return on investment (ROI).

4. Compute & explain residual income & economic value added (EVA)

LEARNING OBJECTIVES

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Responsibility Accounting SystemManagement Control Systemmeasures the results of

responsibility centers according to information managers need to operate their centers

approaches to manage their diverse and complex activities: ◦centralized◦Decentralized freedom for lower

manager to make decision (autonomy)

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Management Control System Approach

LO 1

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Pros & Cons of Decentralization

Benefit• For ease of

gathering, using local information

• To focus central management

• To train & motivate segment managers,

• To enhance competition & expose segments to market forces

Cost• Leads to

suboptimal (incongruent) decision making

• Focuses the manager’s attention on the subunit rather than company as a whole

• Increase the costs of gathering information

• Results in duplication activities

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DivisionsFirm commonly desentralize by

creating ‘divisions’ differentiated by: ◦types of goods or services produced

◦geographic lines◦type of responsibility

Responsibility Center: Is a segment of the business whose manager is accountable for specified sets of activities

LO 1

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Decentralized Divisions Based on types of goods or

services produced

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Responsibility centersMajor types of responsibility centers are:

◦Cost centers Manager responsible for cost only

◦Revenue center Manager responsible for sales only

◦Profit center Manager responsible for sales & costs

◦Investment center Manager responsible for sales, costs, &

capital investment

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Measuring Performance of Profit Centers

2 ways to calculate income ◦absorption costing ◦variable costing (direct costing)

They differ in the treatment of fixed factory overhead.

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Inventory Valuation: Background

Units in beginning inventory 0Units produced 10,000Units sold ($300 per unit) 8,000Variable costs per unit

Direct materials $ 50 Direct labor 100 Variable overhead 50

Fixed costs Fixed overhead per unit produced 25 Fixed selling & administrative 100,000

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Absorption Costing Direct materials $ 50 Direct labor 100 Variable overhead 50 Fixed overhead per unit produced 25Unit product cost $ 225

Value of ending inventory =

2,000 x $ 225 = $ 450,000

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Variable Costing Direct materials $ 50 Direct labor 100 Variable overhead 50 Unit product cost $ 200

Value of ending inventory =

2,000 x $ 200 = $ 400,000

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Absorption Income Statement

Sales ($300 x 8,000) $ 2,400000Less Cost of goods sold 1,800,000Gross margin $ 600,000Less S&A expenses 100,000Operating income $ 500,000

CGS = 8,000 x $ 225

= $1,800,000

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Variable Income StatementSales $ 2,400,000Less variable expenses 1,600,000Contribution margin 800,000Less fixed costs 350,000Operating income $ 450,000

Variable costs: 8,000 x $200

Fixes costs: $250,000 + 100,000

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Absorption vs. Variable

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Absorption vs VariableGenerally accepted accounting principles (GAAP)

require absorption costing for external reportingvariable costing is an invaluable managerial tool,

can supply vital cost information for decision making and control

The difference between variable costing & absorption costing year to year is equal to the change in fixed overhead. ◦ Under absorption costing, fixed overhead is assigned to

inventory produced. ◦ Under variable costing, fixed overhead is a period expense

Absorption-costing income – Variable-costing income = Fixed overhead rate x (Units produced – Units sold)

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Exercise 10-3

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Solution1. Fixed Overhead Rate = 107500/ 25000 = 4.3

Perbedaan Income Absorpsi - Variable:=Fixed Overhead Rate x

(Unit Produced - Unit Sold) = $4.3 x (25000-23000)= $8,600

a. Income Statement Variable Costing

Sales $ 598,000 Less: Variable Expenses

Variable COGS $ 294,400 Variable Selling & Adm Expenses $ 92,000

$ 386,400 Contribution Margin $ 211,600 Less: Fixed Expenses

Fixed Overhead $ 107,500 Fixed Selling & Adm Expenses $ 26,800

$ 134,300 Operating Income $ 77,300

b. Income Statement Absorption Costing

Sales $ 598,000 Less: COGS $ 393,300 Gross Margin $ 204,700 Less: Selling & adm $ 118,800 Operating Income $ 85,900

85,900 – 77,300 = $8,600

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Evaluating Profit-Center Managers Variable costing ensures that direct

relationship between sales & income holds whereas absorption costing does not

The product cost under variable costing is $10 per unit for both years

the product cost under absorption costing is $20 per unit in 2007 and $30 per unit in 2008 (assuming expected actual volume used to compute predetermined FO rate)

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Under variable costing, income increased by $75,000 (from -$25,000 to a profit of $50,000).

However, under absorption costing, operating income decreased by $25,000 (from a profit of $25,000 to $0) despite the increase in sales!

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Segment ReportingSegment is a subunit of a

company of sufficient importance to warrant performance reports

Can be in form of: divisions, department, product lines, etc.

Fixed expenses on Segmented income statement:◦ Direct fixed expenses◦Common Fixed expenses

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Fixed ExpensesDirect fixed expenses are directly

traceable to a segment & therefore avoidable. If segment eliminated, so are expenses◦ i.e: rent for regional office /a product line

warehouseCommon fixed jointly caused by two or

more segments. These expenses persist even if one of the segments to which they are common is eliminated◦ i.e: CEO salary, headquarter building

depreciation

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Comparative income statementsSegment margin is contribution to firm’s common fixed costs.

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Exercise 10-4

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Measuring the Performance of Investment Centers Using ROIROI relates operating profits to

assets employed.

Operating income = earnings before interest and taxes

Operating assets = all assets acquired to generate operating income, including cash, receivables, inventories, land, buildings, and equipment

ROI = Operating Income

Average Operating Assets

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Margin & TurnoverMargin tells how many cents of

operating income result from each dollar of sales

Turnover tells how many dollars of sales result from every dollar invested in operating assets.

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Exercise 10-6

OI = sales – expenses = 50.000 – 48.000 = 2.000 Margin = OI/Sales = 2.000/50.000 = 4% Turnover = Sales/Operating asset = 50.000/10.000 = 5x ROI = Margin x Turnover = 4% x 5 = 20%

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Illustration

Computing the margin and turnover ratios for each division gives a better picture of what caused the change in rates

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ROI Pros & ConsPros

• Encourages managers to focus on• Relationship

among sales, expenses

• Cost efficiency• Operating asset

efficiency

Cons• Can product a

narrow focus on divisional profitability at expense of profitability for overall firm

• Encourages managers to focus on short run at expense of long run

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Focus on short run at expense of long run - exampleLay off five of the highest-paid

salespeople.Cut the advertising budget for the

fourth quarter by 50 percent.Delay all promotions within the division

for three months.Reduce the preventive maintenance

budget by 75 percent.Use cheaper raw materials for fourth-

quarter production.

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Measuring the Performance of Investment Centers Using Residual IncomeResidual income is the difference

between operating income and minimum dollar return on sales.

Minimum rate of return = hurdle rate of the divisions/projects

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ADVANTAGES & DISADVANTAGES: Residual Income

Advantage• Gives

another view of project profitability

Disadvantages

• Can encourage short run orientation

• Direct comparisons are difficult

LO 4

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Exercise 10-11

Required Compute Residual Income of each scenario Compute ROI of each scenario

◦ The MP3 player is added.◦ The voice recorder is added.◦ Both investments are added.◦ Neither investment is made; the status quo is maintained

Which alternatives that should manager choose, if the performance evaluation based on (1) ROI, (2) Residual Income?

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AnswerROI MP3 Player 14.50%ROI Voice recorder 14.00%Residual Income MP3 Player $20,000.00 Residual Income Voice Recorder $15,000.00

Alternatives Without Investment MP3 Player Voice recorder Both Projects

Operating income 2,700,000.00 2,816,000.00 2,805,000.00 2,921,000.00

Operating Asset 18,000,000.00 18,800,000.00 18,750,000.00 19,550,000.00

ROI 15.00% 14.98% 14.96% 14.94%

Minimum required rate 12% 12% 12% 12%

Residual income 540,000.00 560,000.00 555,000.00 575,000.00

ROI: Loss on not selecting both project

Operating income if invested in assets $221,000

operating asset $1,550,000

Fund invested at 12% $186,000

Loss on not invest in projects $35,000

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Economic Value Added (EVA)EVA links net income (return) to capital

employed

EVA is a dollar figure, not a percentage rate of return (as a form of residual income)

if EVA is positive, then the company is creating wealth; if EVA is negative, then the company is destroying wealth

Economic value added (EVA)

= After Tax Operating Income – (% cost of capital x

Capital employed)

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Cost of Capital◦C* = [y x (Equity/CAPITAL)] + (1+t) x i x (Debt/CAPITAL)

y = required rate of return on equity

t = marginal tax ratei = interest rate for debtCapital = equity + debt

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Illustration EVA calculation

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THE END

CHAPTER 10