Managerial Accounting
Class Notes and Lecture Outline
Segmental Analysis
A responsibility accounting system seeks to provide information by which to evaluate each manager on the revenue and expense items over which the manager has control (the authority to influence).
  • Each report contains only (or at least segregates) those items that are primarily controllable by the responsible manager.
  • Clear lines of authority and responsibility are helpful in setting up a responsibility accounting system.
  • Items that are not controllable at one level are controllable at some higher level.
The reports issued under a responsibility accounting system are interrelated since the totals from one level are carried forward in the report to the next higher management level.
  • The aggregation that occurs at successive levels of management is justified on the basis that the appropriate manager will take the necessary corrective action.
  • Managers should be able to describe to their superiors actions that have been taken to correct undesirable situations.
  • Items that are noncontrollable at a given level may be omitted entirely from the report for the manager at that level or they may be segregated and clearly labeled in the report. At the management level at which these items become controllable, they are included in the report.
  • Reports must be timely to allow prompt corrective action to be taken.
Responsibility centers may be expense centers, profit centers, or investment centers.
  1. Expense centers are held responsible only for specified expense items; they produce no direct revenue from the sale of goods or services. The goal of an expense center should be to minimize long-run expenses for any given level of output.
  2. Profit centers have both revenues and expenses, and, therefore, permit a calculation of income for the segment under consideration. The segment manager in a profit center has the authority to control selling price, sales volume, and all of the reported expense items.
  3. Investment centers have revenues, expenses, and a specified investment base; they calculate income and divide that income by an appropriate investment base to determine ROI.
    • All of the problems inherent in the expense center and profit center concepts are present, plus the question of selecting a “proper” investment base.
    • The logic for using investment centers for evaluation purposes is that segments with larger resources should produce larger profits.
The greater the degree of decentralization, the more applicable is the investment center concept.
  1. A segment manager must have control over revenues, expenses, and assets of the segment for the investment concept to be applied.
  2. Typical investment centers are large, autonomous segments of very large companies.
  3. Decentralization has the following advantages:
    • Segment managers become better qualified to move into top management positions.
    • Top management can be more removed from day-to-day decision making.
    • Decisions can be made at the point where problems arise.
    • Since the investment center concept is applicable, performance criteria such as return on investment and residual income can be used.
The concepts of direct cost (expense) and indirect cost (expense) are applicable to segmental analysis.
  1. A cost is only “direct” or “indirect” in relation to a cost object.
  2. A direct cost object of a cost (e.g., a segment) is one which is specifically traceable to that object. It would most likely disappear if the object were eliminated.
  3. An indirect cost of a cost object is one that is not traceable to that object, but is allocated to it on some basis. If the cost object ere eliminated, the indirect cost would probably continue to exist and would be allocated elsewhere.
The net income of a segment is found in the following way:
Sales                                 $ XX
Less: Variable expenses                 XX
Contribution margin                   $ XX
Less: Direct fixed expenses             XX
Contribution to indirect expenses     $ XX
Less: Indirect fixed expenses           XX
Net income                            $ XX

The computation of net income involves arbitrary allocations of indirect fixed expenses.

Allocations of indirect fixed expenses are made on the basis of benefit, responsibility, or some other basis (such as net sales). [E9-3] [E9-4]

The contribution to indirect expenses is useful for determining the amount that a segment contributes to company profit. It shows the amount by which company profit would decline if the segment were eliminated.
The investment center concept is implemented by introducing the concept of investment base into the analysis. This is accomplished by calculating return on investment (ROI) or residual income (RI).
Return on investment (ROI) is calculated as follows:

ROI  =  income / investment

1.  The definitions of “income” and “investment” vary according to what is being evaluated.
a)    If the purpose is to evaluate the earning power of a company then:
ROI  =  Net Income / Total Assets or   ROI  =  Net Operating Income / Operating Assets

b)    If the rate of income contribution of a segment is being evaluated then:
ROI  =  Contribution to Indirect Expenses / Assets directly used by the segmrnt

2.  Various valuation bases may be used for plant assets in the ROI computation.
     They are original cost less depreciation, original cost, or current replacement cost.

3.  The ROI formula can be divided into two components, “margin” and “turnover,” to aid in setting strategy to increase ROI.
     The expanded version of the formula is:
ROI  =  Margin  x  Turnover
ROI  =  [Income / Sales]  x  [Sales / Investment]
Residual income can be calculated to avoid the problem of suboptimization (taking an action which benefits the segment but which is not in the best interest of the company).

Residual income is found as follows:
Residual income = Income - (Investment x Cost of capital).
          
The definitions of “income” and “investment” in the residual income formula are similar to those in the return on investment formula for evaluating the income contribution of a segment or the income performance of a manager.

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last updated August 24, 2007