2. Outline
• Definition of decentralization
• Decentralization in organization
• Decentralization & segment reporting
• Segmented reporting & profitability analysis
• Hindrance in proper cast assignment in
segmented reporting
• Segmented financial information on external
reports
3. Definition of Decentralization
• Decentralization (or decentralisation) is the
process of redistributing or dispersing functions,
powers, people or things away from a central
location or authority.
—— Wikipedia
4. Definition of Decentralization
• A decentralized organization is one in which
decision making is not confined to a few top
executives but rather is throughout the
organization, with managers at various levels
making key operating decisions relating to their
sphere of responsibility. Decentralization is a
matter of degree, since all organizations are
decentralized to some extent out of necessity.
5. Decentralization in organization
• In a decentralized company, managers of
separate divisions or units are delegated
operating responsibility. The division (unit)
managers are responsible for planning and
controlling the operations of their divisions.
6. Advantages of Decentralization
Relieves the Top Executives of Excessive Workload.
Managerial Development
Increase in morale of employees
Quicker and better decisions
Improvement in Industrial Relations
Expansion of Market
Increase in Initiative
Reduces problem of Communication
7. Disadvantages of Decentralization
Dependence on the ability of subordinates
Lack of cooperation
Lack of uniformity of decision
difficult to effectively spread innovative ideas.
Costly set- up
Lack of control
8. Decentralization & Segment Reporting
• What is the segment?
A segment is a part or activity of an organization about
which managers would like cost, revenue or profit data.
Examples of segments include divisions of a company,
sales territories, individual stores, service centers,
manufacturing plants, marketing departments, individual
customers and product lines.
9. Decentralization & Segment Reporting
• Categorization of business segment
cost centers
profit centers
investment centers
responsibility centers
10. Decentralization & Segment Reporting
• Relationship of D&SR
Effective decentralization requires segment reporting. In
addition to the companywide income statement, reports
are needed for individual segments of the organizations.
These segmented income statements are useful in
analyzing the profitability of segments and measuring the
performance of segment managers.
11. Traceable and common fixed costs
• The most puzzling aspect of segmented income
statements is probably the treatment of fixed costs.
While preparing segmented income statements the fixed
cost is divided into two parts one is traceable fixed cost
and other is common fixed cost. Only traceable fixed
costs are assigned to the segment. If a cost is not
traceable then it is not assigned to segments. Following
paragraphs define explain these two types of fixed costs.
12. Traceable and common fixed costs
• Traceable fixed cost
A traceable fixed cost is a fixed cost that is incurred because of the
existence of a segment. If the segment had never existed, the fixed
cost would have not been incurred; and if the segment were
eliminated, the fixed cost would disappear.
13. Traceable and common fixed costs
• Examples of Traceable fixed cost
1. The salary of the Fritos product manager at Pepsi CO. is traceable
fixed cost of the Fritos business segment of Pepsi Co.
2. The liability insurance at Disney World is a traceable fixed cost of
the Disney World business segment of the Disney Corporation
14. Traceable and common fixed costs
• Common fixed cost:
A common fixed cost is a fixed cost that supports the operations of
more than one segment, but is not traceable in whole or in part to
any one segment. Even if a segment were entirely eliminated, there
would be no change in true common fixed cost.
15. Traceable and common fixed costs
• Example of Common fixed cost:
• The salary of general manager who controls all the segments. The
salary of CEO at general motors is also an example of common
fixed cost. No single segment can be regarded as the sole reason of
this cost.
• The salary of receptionist at an office shared by a number of doctors
is a common fixed cost of the doctors. The cost is traceable to the
office, but not to any one of the doctors individually.
16. Traceable and common fixed costs
• Identifying traceable and common fixed costs is crucial in
segment reporting, since the traceable fixed costs are
charged to the segments and common fixed costs are
not charged to segments. In actual situations, it is some
times hard to determine whether a cost should be
classified as traceable or common. The general
guideline is to treat as traceable costs only those costs
that would disappear over time if the segment itself
disappeared.
17. Traceable and common fixed costs
• Traceable cost can become common cost:
• Fixed cost that is traceable to one segment can become a common cost for
another segment. For example, an air line might want a segmented income
statement that shows the segment margin for a particular flight from Loss
Angeles to Paris further broken down into first class, business class and
economy class segment margins. The airline must pay a landing fee
Charles DeGaulle air port in Paris. This fixed landing fee is a traceable fixed
cost of the flight, but it is a common fixed cost of first class, business class
and economy class segments. Even the first class cabinet is empty the
entire landing fee must be paid. So the landing fee is not a traceable cost of
the first class segment. But on the other hand paying the landing fee is
necessary in order to have any first, business and economy class
passengers. So the landing fee is common cost for these three class of
passengers and is a traceable cost for the flight as a whole.
18. Segment Reporting and Profitability Analysis-
Segmented Income Statements
• How are segmented income statements prepared?
A different kind of income statement is required for evaluating the
performance of a profit or investment center. This income statement
should emphasize on the segment rather than the performance of the
company as a whole. A contribution margin format income statement is
used to evaluate the performance of different segments. In a contribution
margin format income statement cost of goods sold consists only of the
variable manufacturing costs. This point has been discussed in detail on
our cost volume profit CVP relationship page. To prepare an income
statement for a particular segment variable costs are deducted from the
sales revenue to yield contribution margin. Fixed costs are broken down
further into traceable and common fixed costs. Traceable fixed are
assigned to the segments but non-traceable or common fixed costs are
not assigned to segments. For detailed study about traceable and
common fixed costs see traceable and common fixed cost page.
19. Segment Reporting and Profitability Analysis-
Segmented Income Statements
• Segment Margin:
• The segment margin is obtained by deducting the traceable fixed
costs of a segment from contribution margin. It represents the
margin that is available after a segment has covered all of its own
costs. The segment margin is the best gauge of the long-run
profitability of a segment, since it includes only those costs that are
caused by the segment. If a segment cannot cover is own costs,
then that segment probably should not be retained (unless it has an
important side effects on other segments).
• From a decision making point of view, the segment margin is most
useful in major decisions that effect capacity such as dropping a
segment. By contrast, the contribution margin is most useful in
decisions relating to short-run changes in volume, such as pricing
special orders that involve utilization of existing capacity.
20. Segment Reporting and Profitability Analysis-
Segmented Income Statements
• Example: 1
• As an example, a portion of the segmented report is shown below.
In this report segments have been defined as divisions. Report also
have a column of total company performance for the period. We can
see that divisional segment margin is $60,000 for business product
division and $40,000 for the consumer product division. This report
is very useful for company's divisional managers They may want to
know how much each of their divisions is contributing to the
company's profit.
22. Segment Reporting and Profitability
Analysis-Segmented Income
Statements
• Example: 2
• Segmented income statements can be prepared for activities at
many levels in a company. To provide more information to the
company's divisional managers the divisions can be further
segmented according to their major product lines. In the consumer
product division the product lines are clip art and computer games.
This concept is further explained by the following example.
24. Segments defined as product lines of
the consumer product division
• Conclusion of example 2
• Total traceable cost ($80,000) of consumer product division include
10,000 of divisional manager's salary. This cost now is a common
fixed cost for clip art and computer games. Because non of these
products is solely responsible for this salary of manager.
• Going even further , we can segment each of the product lines
according to how they are sold--in retail computer stores or by
catalog sales.
25. Segments defined as sales channels for one product line,
computer games, of the consumer products division
26. Segments defined as sales channels for one product line,
computer games, of the consumer products division
• Substantial benefits are received from a series of
statements of such as those above. By carefully
examining trends and results in each segment, a
manager is able to gain considerable insight into the
company's operations viewed from many different
angles. And advanced computer-based information
systems are making it easier and easier to construct
such statements and to keep them continuously current.
27. Hindrances/Problems to Proper Cost
Assignment in Segmented Reporting
• Omission of costs
• Arbitrarily dividing common costs among
segments
• Inappropriate methods for allocating costs
among segments
a. Failure to trace cost directly
b. Inappropriate Allocation Base
28. Omission of costs
• The costs assigned to a segment should include all
costs attributable to that segment from the company's
entire value chain. The value chain consists of major
business functions that add value to a company's
products and services. All of these functions, from
research and development, through product design,
manufacturing, marketing, distribution, and customer
service, are required to bring a product or service to
the customer and generate revenues. However only
manufacturing costs are included in product costs for
financial reporting purposes, some companies deduct
only manufacturing costs from product revenues.
29. Omission of costs
• As a result such companies omit from their profitability
analysis part or all or the "upstream costs“ in the value
chain which consist of research and development and
product design, and "down stream costs“ which consist
of marketing, distribution and customer service. Yet these
non manufacturing costs are just as essential in
determining the product profitability as are the
manufacturing costs. These upstream and downstream
costs, which are usually titled selling, general and
administrative (SG&A) on the income statement, can
represent half or more of the total costs of an
organization. If either the upstream or downstream costs
are omitted in profitability analysis, then the product is
under-costed and management may unwillingly develop
and maintain products that in the long run result in losses
rather than profits for the company.
30. Arbitrarily dividing common costs
among segments
• The third business practice that leads to distorted
segment costs is the practice of assigning non-traceable
costs to segments. For example, some companies
allocate the costs of the corporate headquarters building
to products on segment reports. However, in a
multiproducts company, no single product is likely to be
responsible for any significant amount of this cost. Even if
a product were eliminated entirely, there would usually be
no significant effect on any of the costs of the corporate
headquarters building. In short, there is nocause and
effectrelation between the cost of the corporate
headquarters building and the existence of any one
product. As a consequence, any allocation of the cost of
the corporate headquarters building to the products must
be arbitrary.
31. Arbitrarily dividing common costs
among segments
• Common costs like the costs of corporate headquarters building are necessary, of
course, to have a functioning organization. The common practice of arbitrarily
allocating these costs to segments is often justified on the grounds that "someone"
has to "cover the common costs." While it is undeniably true that the common
costs must be covered, arbitrarily allocating common costs to segments does not
ensure that this will happen. In fact, adding a share of common costs to the real
costs of a segment make an otherwise profitable segment appear to be
unprofitable. If a manager erroneously eliminates the segment, the revenues will
be lost, the real costs of a segment will behaved, but the common cost will still be
there. The net effect will be to reduce the profit of the company as a whole and
make it even more difficult to "cover the common costs." In sum, the way many
companies handle segment reporting results in cost distortion. This distortion
results from three practices--the failure to trace costs directly to specific segment
when it is feasible to do so, the use of inappropriate bases for allocating costs, and
the allocation of common costs to segments. These practices are widespread.
One study found that 60% of the companies surveyed made no attempt to assign
SG&A costs to segments on a cause and effect basis.
32. Inappropriate methods for allocating
costs among segments
• Cross-subsidization, or cost distortion, occurs when costs
are improperly assigned among a company's segment.
Cross-subsidization can occur in two ways; first, when
companies fail to trace costs directly to segments in those
situations where it is a feasible to do so; and second,
when companies use inappropriate bases to allocate
costs.
33. Failure to trace cost directly
• Costs that can be traced directly to a specific
segment of a company should not be allocated
to other segments. Rather, such costs should be
charged directly to the responsible segment. For
example, the rent for a branch office should be
charged directly against the branch office rather
than included in a company wide overhead pool
and then spread throughout the company.
34. Inappropriate Allocation Base
• Some companies allocate costs to segments using arbitrary
bases such as sales dollars or cost of goods sold. For example,
under the sales dollars approach, costs are allocated to the
various segments according to the percentage of company sales
generated by each segment. If a segment generates 20% of
total company sales, it would be allocated 20% of the company's
SG&A expenses as its fair share. This same basic procedure is
followed if cost of goods sold or some other measure is used as
the allocation base. For this approach to be valid, the allocation
base must actually drive the overhead cost. Or at least the
allocation base should be highly correlated with the cost driver of
the overhead cost. For example, when sales dollars is used as
the allocation based for SG&A expense, it is implicitly assumed
that SG&A expense change in proportion to change in total
sales. If that is not true, the SG&A expenses allocated to
segments will be misleading.
35. Segmented Financial Information on
External Reports
The Financial Accounting Standards Board (FASB) now requires that companies in
the united states include segmented financial and other data in their annual
reports and that the segmented reports prepared for external users must use the
same method and definitions that the companies use in internal segmented
reports that are prepared to aid in making operating decisions. This is a very usual
requirement. Companies are not ordinarily required to report the same data to
external users that are reported internally for decision making purposes. This may
seem like a reasonable requirement for the FASB to make, but it has some serious
drawbacks. First segmented data are often highly sensitive and companies are
reluctant to release such data to the public for the simple reason that their
competitors will then have access to the data. Second companies must reconcile
their segmented financial statements, which need not be prepared under
Generally Accepted Accounting Principles (GAAP). It is important to realize that
the segmented income statement prepared on
Segment reporting and profitability analysis-segmented income statements page
does not conform to GAAP. For example statements prepared in accordance with
GAAP do not distinguish between fixed and variable costs and between traceable
and common costs. To avoid the complications of the reconciliations between non-
GAAP segment earnings and GAAP consolidated earnings, it is likely that at least
some managers will choose to construct their segmented financial statements so
as to be within GAAP. This will result in more occurrences of the problems.
