Segment Reporting and Performance Evaluation
Things You Must Know
Introduction to Accounting
Executive management makes all decisions related to the organization
Decisions are made in the organization at various levels of management
Effective decentralization requires “Segment Reporting” performance reports for
individual parts of the business that managers are responsible for
Part or activity of the business where revenue or cost data is necessary
Managers are evaluated based on revenues, cost or profit of their segment
A segment will be a cost, profit or investment center
Examples of segments are: sales territories, manufacturing divisions, product lines, departments within an organization
Responsibility Accounting System:
Structured around cost, profit, and investment centers to provide information for performance evaluation.
The manager is responsible for controllable costs; generates no revenue
Examples: accounting, human resources, information systems, legal and administrative, and other support departments
Expected to minimize costs while providing service to the organization
The manager is responsible for both revenues and controllable costs
A part of the business that produces and sells a product or service
Often evaluated by comparing actual profits to budgeted profits
The manager is responsible for revenue, controllable costs, and investment in assets. (ex: the division manager)
A different kind of income statement is required for evaluating the performance of a profit center or an investment center
The format is a contribution margin / variable costing income statement.
There is a total company column and a separate column for each segment
Sales and costs direct to the segment go in that segment’s column
Only traceable/direct fixed costs are reported in the segment column
A traceable/direct fixed is one that will go away if the segment goes away
Variable costs are always direct to the segment
Costs that support the operations of more than one segment are not reported in the segment column to determine segment profitability.
These costs are reported in the total company column only.
These costs are referred to as allocated, common, nontraceable, corporate
The best measure of profitability for each segment is the “division or segment margin” (segment means the same thing as division)
Total Div.1 Div. 2
– Variable cost of production
– Variable period costs
= Contribution Margin
– Traceable/direct fixed costs
= Division segment margin (profit)
– Common / allocated/ nontraceable costs
= Total operating income
The statement is sorted by variable and fixed costs.
Fixed costs are then sorted as traceable (direct) or nontraceable common/allocated/corporate)
Traceable (direct) costs:
Costs that would not be incurred if the segment or division were to be discontinued.
Only traceable or direct costs are charged to segments
Costs incurred in support of more than one segment.
These costs will be incurred regardless of whether or not the segment is operating.
If the segment is not operating, the costs will be allocated to other segments.
Also called nontraceable, corporate or indirect
Common costs should never be allocated to segments
The profitability of the segment after it has covered all its direct costs.
Variable costs are always direct costs.
The following formulas are most commonly used for performance measurement
Return on Investment
Average Operating Assets
Operating Income is income before interest expense and tax expense
Cash, accounts receivable, inventory, plant and equipment and all other assets that are used in the operations of the business
Average Operating Assets = (beginning + ending) / 2
Plant and equipment is valued at book value
(Cost less Accumulated Depreciation)
Fair market value is not used due to reliability, consistency, and comparability
Break Down of Return on Investment:
Operating Income Sales Sales X Average Operating Assets “Profit Margin” “Asset Turnover” % Profit on $1 of sales Sales generated from the investment in assets
Increase ROI by:
1) increase sales
2) reduce expenses
3) reduce the investment in assets
Criticism of ROI as a performance measurement:
Management evaluated based on ROI tend to reject projects that are less than the current ROI because they will reduce total future ROI.
This is short-term thinking if the project will benefit the total company.
Residual income is the operating income an investment center earns over and above the minimum required rate of return on the investment in assets
Actual Operating Income
– Required Operating Income (see below)
= Residual Income
Average Operating Assets
X Required Rate of Return %
= Required Operating Income
(average = beginning + ending / 2)
Disadvantage to using Residual Income:
Can’t easily compare a division’s performance to other divisions because the size of each division can differ significantly.
Can encourage short term thinking when minimizing the investment in assets increases residual income