Segment Reporting and Performance Evaluation

Things You Must Know

Centralized Organization:
Executive management makes all decisions related to the organization

Decentralized 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.

Cost Center
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

Profit Center
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

Investment Center
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

Common costs:
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

Segment Margin:

The profitability of the segment after it has covered all its direct costs.

Variable costs are always direct costs.

Performance Measurement

The following formulas are most commonly used for performance measurement

Return on Investment

    Operating Income
Average Operating Assets

Operating Income is income before interest expense and tax expense

Operating Assets

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:

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