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ACC 1110 J. Pai

Chapter 11 and Appendix 11 A Reporting for Control

1

EXERCISE 11–1 Basic Segmented Income Statement [LO1] Honeyville Hardware produces and sells two products for professional landscapers: shovels and rakes. Revenue and cost information relating to the products follow: Product Shovels Selling price per unit . . . . . . . .. . . . . . . . . . . . . . . . . $ 10.00 Variable expenses per unit . . . . .. . . . . . .. . . . . . . . . . . . . . . 6.50 Traceable fixed expenses per year ... . . . . . . . . . . . . . . . . . . . . 8,000

Rakes $ 21.00 12.00 25,000

Common fixed expenses in the company total $15,000 annually. Last year the company produced and sold 3,500 shovels and 5,000 rakes. Required: Prepare a contribution format income statement for the year, segmented by product lines.

Total Sales ($10 x 3,500; 5,000) .......... $140,000 Variable expenses ($6.5 x 3,500; $12 x 5,000) ..................

82,750

Contribution margin ....................

57,250

Traceable fixed expenses .............

33,000

Product line segment margin .......

24,250

Common fixed expenses not traceable to products Operating income .......................

$140,000

Shovels

Rakes

EXERCISE 11–1 Basic Segmented Income Statement [LO1] (page 2 of notes)

Implications: Each segment must be self-sufficient (able to pay its own traceable costs) to improve overall corporate operating income. A segmented I/S helps the management to make keep-or-drop a division decision: Segment margin > $0

Keep the division

SM = $0

No financial difference either way; kept for strategic reason such as complementary item.

SM < $0

Drop to improve overall corporate profit, unless there is an up-side potential or the product is a complementary item to another product.

EXERCISE 11–3 Working with a Segmented Income Statement [LO1] Middleton Associates is a consulting firm that specializes in information systems for construction and landscaping companies. The firm has two offices—one in Toronto and one in Vancouver. The firm classifies the direct costs of consulting jobs as variable costs. A segmented contribution format income statement for the company’s most recent year is given below: Office Total Company Toronto Vancouver Sales . . . . . . . . . . . . . . . . . . . . . . . . $750,000 100.0% $150,000 100% $600,000 100% Variable expenses. . . . . . . . . . . . . . 405,000 54.0% 45,000 30% 360,000 60% Contribution margin. . . . . . . . . . . . 345,000 46.0% 105,000 70% 240,000 40% Traceable fixed expenses. . . . . . . 168,000 22.4% 78,000 52% 90,000 15% Office segment margin. . . . . . . . . 177,000 23.6% $ 27,000 18% $ 150,000 25% Common fixed expenses not traceable to offices . . . . . 120,000 16.0% Operating income. . . . . . . . . . . . . . $ 57,000 7.6% Required: 1. By how much would the company’s operating income increase if Vancouver increased its sales by $75,000 per year? Assume no change in cost behaviour patterns. CMR stays the same as long as cost structure unchanged. Seg. Margin Ratiochanges at each sales level because of traceable FC. An increase in o overall verall corpor corporate ate OI of $75,000 × 40% CM rratio atio = $30,000 2. Refer to the original data. Assume that sales in Toronto increase by $50,000 next year and that sales in Vancouver remain unchanged. Assume no change in fixed costs. a. Using the framework provided in the following page to prepare a new segmented income statement for the company using the above format. Show both amounts and percentages. b . Observe from the income statement you have prepared that the CM ratio for Toronto has remained unchanged at 70% (the same as in the above data) but that the segment margin ratio has changed. How do you explain the change in the segment margin ratio?

Exerc Exercise ise 11-3 (Continued) 2. a. The segmented income statement follows:

Total Company Amount % Sales ................. Variable expenses ........ Contribution margin ............ Traceable fixed expenses ........ Office segment margin ............ Common fixed expenses not traceable to segments ........ Operating income............

100.0

Segments Vancouver Toronto Amount % Amount % 200,000 100 $600,000 100 1

52.5

60,000

47.5

140,000

2

21.0

78,000

3

39

4

31 $150,000 25

26.5

62,000

30

360,000 60

70

240,000 40 90,000 15

15.0 11.5

NOTE: Add across to get the total company amount. Common fixed expenses not traceable to segments stays the same as before. Notes1 to 4: Variable expenses; Contribution margin; Traceable fixed; Segment margin divided by Sales. 2b. Suggested Solution: (Concepts) The segment margin ratio changes as sales vary due to the presence of fixed costs. The fixed expenses are spread over a larger base as sales increase. In contrast, the contribution margin ratio is stable so long as there is no change in either variable expenses or the selling price of a unit of service.

Decentralization and Responsibility Centres (Based on E11-5) A responsibility centre is any part of an organization for which a manager is accountable for performance in cost, profit, or investments. For example, it could a flagship like Sheraton Hotel or Westin Hotel under the Westwood flagship. A cost centre is meant to operate within its assigned cost budget, therefore, it is often evaluated using budget variances. Examples include any HR, Selling, Accounting, and Service department in one of the Sheraton or Westin Hotel Group. A profit centre is a business segment where the manager has control over revenue and cost. Examples are Sheraton Vancouver Wall Centre and Westin Resort in Maui, Hawaii. An investment centre is a division who is authorized to make decisions of profit it makes. Its managers are held responsible for the residual income of the segment and for initiating investment proposals. For examples, North America Division of Starwood Hotels & Resorts Worldwide could decide the residual incomes of the Sheraton Anchorage Hotel and Spa be placed in the upgrade of the Spa infrastructure. Two common measures that management uses to evaluate an investment opportunity: 1. ROI =

ROS OI Sales

x

Asset TO

×

Sales Ave. Oper. Assets

 Invest only in projects with a higher ROI than the division’s to make sure divisional ROI will improve as well as divisional profit; despite some may improve overall corporate profits just not the division’s ROI.  The disadvantage is the possible sub-optimization in a division.

2.

Residual Income

=

Expected OI

-

Required OI (from an investment opportunity)

=

Expected OI

-

(Ave. Oper. Assets Used x Required Rate of Rtn.)

 Each division will invest in a project with a positive residual income to improve divisional and corporate OI, despite some of the projects could have a ROI lower than the division’s.

EXERCISE 11–11 Evaluating New Investments Using Return on Investment and Residual Income [LO3, LO4] Three divisions of Jameson Co. report the following sales and operating data: Fitness Training Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 Average operating assets . . . . . . . . . . . . . . . $200,000 Operating income. . . . . . . . . . . . . . . . . . . . . .. $ 30,000 Minimum required rate of return. . . . . . . . . . . . . . 10%

Spa Services $750,000 $250,000 $ 37,500 12%

Athletic Wear $400,000 $100,000 $ 24,000 10%

Required: 1. Compute the ROI for each division, using the formula stated in terms of margin and turnover. 2. Compute the residual income for each division. 3. Assume that each division is presented with an investment opportunity that would yield a rate of return of 17%. a. If performance is being measured by ROI, which division or divisions will probably accept the opportunity? Reject it? Why? b. If performance is being measured by residual income, which division or divisions will probably accept the opportunity? Reject it? Why?

Exerc Exercise ise 11-11 (Solution) 1. Computation of ROI. x

ROS

Fitness training:

=

ROA

=

ROI

$30,000 × $600,000 $600,000 $200,000 5%

×

3

=

Spa services: 37,500 / 750,000 x 750,000 / 250,000 = 5% x 3% = 15%

Athletic wear: 24,000 / 400,000 x 400,000/100,000 = 6% x 4% = 24%

15%

Exerc Exercise ise 11-11 (Solution Continued)

2.

Fitness Training

Spa Services

Athletic Wear

$250,000 $100,000 12% × 10% Required rate of return........ × 10% × Required operating income $20,000 $30,000 $10,000 Average operating assets.....

$200,000

$ 30,000 20,000 ...... Required O.I. (above) .. Actual operating income .........

3. a. and b. Decision Chart Return on investment (ROI) ... Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would................................. Minimum required return for computing residual income Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would.................................

37,500 37,500

24,000 24,000

$ 10,000

Fitness Training

Spa

Athletic wear

15%

15%

24%

Accept

10% Accept

Accept

12% Accept

Reject (taking anything less than 24% would bring down ROI)

10% Accept

Exercise 11-11 (Solution Continued)

THEORY SUPER IMPORTANT FOR FINAL!!!!! 3 a & 3 b Summary If performance is being measured by ROI, the Athletic Wear division probably would reject the 17% investment opportunity. The reason is that this division is presently earning a return greater than 17%; thus, the new investment would reduce the overall rate of return and place the divisional managers in a less favourable light. The Fitness Training and Spa Services divisions probably would accept the 17% investment opportunity, since its acceptance would increase these divisions' overall rate of return.

If performance is being measured by residual income, all three divisions would accept the 17% investment opportunity. The 17% rate of return promised by the new investment is greater than their required rates of return of 10% and 12%, respectively, and would therefore add to the total amount of their residual income.

When the performance is being measured by residual income, the Athletic Wear division will risk lowering its divisional ROI to accept an opportunity resulting in residual income to improve overall corporate profit. Therefore, residual income approach can reduce divisional sub- optimization (refer to chapter 10, Case 10-36).

PROBLEM 11–15 Finely Segmented Income Statements [LO1] Severo S.A. of Sao Paulo, Brazil, is organized into two divisions. The company’s contribution format segmented income statement (in terms of the Brazilian currency, the real, R) for last month is given below: Total Company Sales . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . R3,500,000 Variable expenses . .. . . . . . . . . . . . . . 1,721,000 Contribution margin. . . . . . . .. . . . . . . . . . 1,779,000 Traceable fixed expenses: Advertising. . . . . . . . . . . . . . . . . . . . . . . . . . . 612,000 Selling and administrative . . .. . . . . . . . . . . . 427,000 Depreciation. . . . . . . . . . . . . . . . . . . . . . . . 229,000 Total traceable fixed expenses .. . . . . . . . 1,268,000 Divisional segment margin ... . . . . . . . . 511,000 Common fixed expenses . . . . . . .. . . . 390,000 Operating income . . . . . . . . . . . . . .. . . . R 121,000

Division Cloth R2,000,000 960,000 1,040,000

Leather R1,500,000 761,000 739,000

300,000 210,000 115,000 625,000 R 415,000

312,000 217,000 114,000 643,000 R 96,000

Top management can’t understand why the Leather Division has such a low segment margin when its sales are only 25% less than sales in the Cloth Division. As one step in isolating the problem, management has directed that the Leather Division be further segmented into product lines. The following information is available on the product lines in the Leather Division: Leather Division Product Line Garments Shoes Handbags R500,000 R700,000 R300,000

Sales . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . Traceable fixed expenses: Advertising. . . . . . . . . . . . . . .. . . . . . . . . . . . R 80,000 Selling and administrative . . . . . . . . . . . . . . R 30,000 Depreciation. . . . . . . . . . . . . . . . . . . . .. . . . . R 25,000 Variable expenses as a percentage of sales.. . .. .. . 65%

R 112,000 R 35,000 R 56,000 40%

R 120,000 R 42,000 R 33,000 52%

Analysis shows that R110,000 of the Leather Division’s selling and administrative expenses are common to the product lines. PLUS total selling and admin for the 3 lines separately = 107,000 Makes sense because 110,000 + 107,000 = 217,000 = total selling and admin for Leather. Required: 1. Prepare a contribution format segmented income statement for the Leather Division, with segments defined as product lines.

ACC 1110 J. Pai

Chapter 11 and Appendix 11 A Reporting for Control

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Problem 11-15 (Solution) 1. Segments defined as product lines:

Product Line Leather Division

Garments

Shoes

Handbags

R1,500,000

R500,000

R700,000

R300,000

761,000 739,000

325,000 175,000

280,000 420,000

156,000 144,000

Advertising ........................ Administration ...................

312,000 107,000

112,000

120,000

Depreciation ...................... Total traceable fixed expenses........................... Product line segment margin

114,000

80,000 30,000 25,000

35,000 56,000

42,000 33,000

533,000

135,000

203,000

195,000

206,000

40,000

217,000

(51,000)

Sales ................................... Var. exp. (65%; 40% 52%) .. Contribution margin ............. Traceable fixed expenses:

Common fixed expenses: Administrative*.................. Divisional segment margin....

110,000 R

96,000

ACC 1110 J. Pai

Chapter 11 and Appendix 11 A Reporting for Control

11

PROBLEM 11–15 Finely Segmented Income Statements [Continued] Required: 2. Management is surprised by the handbag product line’s poor showing and would like to have the product line segmented by market. The following information is available about the markets in which the handbag line is sold:

Domestic R200,000

Sales. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . Traceable fixed expenses: Advertising. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . R 40,000 Variable expenses as a percentage of sales . . ... . . .. . . . . . . . 43%

Handbag Markets Foreign R100,000 R 80,000 70%

All of the handbag product line’s selling and administrative expenses and depreciation are common to the markets in which the product is sold. Prepare a contribution format segmented income statement for the handbag product line with segments defined as markets. 40k + 80k reconciles (Solution)

Sales .................................. Variable expenses ............... Contribution margin ............ Traceable fixed expenses: Advertising ...................... . Market segment margin ....... Common fixed expenses: Administrative................... Depreciation ..................... Total common fixed expenses (195 – 40 – 80) .......................... Product line segment margin

NOTE: The 195,000 comes from the previously determined total traceable fixed expenses for leather.

ACC 1110 J. Pai

Handbags

Chapter 11 and Appendix 11 A Reporting for Control

Sales Market Domestic Foreign

12

R300,000 R200,000 R100,000 156,000 86,000 70,000 144,000 114,000

30,000

120,000 40,000 24,000 74,000

80,000 (50,000)

42,000 33,000 75,000 R(51,000)

PROBLEM 11–15 Finely Segmented Income Statements [Continued] Required: 3. Refer to the statement prepared in (1) above. The sales manager wants to run a special promotional campaign on one of the product lines over the next month. A marketing study indicates that such a campaign would increase sales of the Garments product line by R200,000 or sales of the Shoes product line by R145,000. The campaign would cost R30,000. Show computations to determine which product line should be chosen. (Solution)

Garments

Shoes

Contribution margin (a) ..................... R175,000 Sales (b) .......................................... R500,000 Contribution margin ratio (a) ÷ (b) .... 35%

R420,000 R700,000 60%

Note: incremental contribution margin = CMR x increase in sales

Incremental contribution margin: 35% x R200,000 increased sales

R70,000

60% x R145,000 increased sales 30,000 Less: cost of the promotional campaign ....................................... Increased operating income............... R40,000

R87,000 30,000 R57,000

Based on these data, the campaign should be direct toward the shoes product line. Notice that the analysis uses the contribution margin ratio rather than the segment margin ratio because

FIXED EXPENSES do not change

PROBLEM 11–18 Return on Investment and Residual Income [LO3, LO4] Financial data for Bridger Inc. for last year are as follows: BRIDGER INC. Balance Sheet Ending Balance

Beginning Balance

$ 150,000 500,000 510,000 840,000 450,000 270,000 $2,720,000

$ 145,000 360,000 590,000 865,000 420,000 270,000 $2,650,000

$ 340,000 1,000,000 1,380,000 $2,720,000

$ 380,000 1,000,000 1,270,000 $2,650,000

Assets Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plant and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . Investment in Brier Company. . . . . . . . . . . . . . . . . . . . . . Land (undeveloped). . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and shareholders’ equity Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ equity . . . . . . . . . . . . . BRIDGER INC. Income Statement Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operatin...