Responsibility Accounting

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CHAPTER 25
RESPONSIBILITY ACCOUNTING SEGMENTAL ANALYSIS
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Responsibility Accounting

• Def. - An accounting system that collects,
  summarizes and reports accounting data relating
  to responsibilities of individual managers.
• It enables evaluation of managers by analyzing
  how well they manage those items under their
  control.
• Therefore, responsibility reports should
  concentrate on controllable items.

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Responsibility Accounting

• Successful implementation of the system depends
  on proper organization so that responsibility is
  assignable to individual managers.
• Formal lines of authority and responsibility
  should be fully defined.
• Organization charts such as the
  following are used as a basis
  for responsibility reporting.

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Organization Chart
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Responsibility Reports
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Responsibility Reports

• Amount of detail varies according to level in
  organization.
• Department manager receives detailed report.
• Store manager receives summarized information
  from each department.
• Vice president of operations receives summarized
  information from each store.
• Management by exception (again)
• A given level of management does not receive
  detail from lower levels unless needed.
• e.g., VP could get store managers report

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Responsibility Reports
Responsibility reports should . . .
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Segments

• A segment is any part or activity of an
  organization about which a manager seeks cost,
  revenue, or profit data. A segment can be . . .

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Segments

• A segment is any part or activity of an
  organization about which a manager seeks cost,
  revenue, or profit data. A segment can be . . .

Quick Mart
An Individual Store
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Segments

• A segment is any part or activity of an
  organization about which a manager seeks cost,
  revenue, or profit data. A segment can be . . .

A Department
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Segments

• A segment is any part or activity of an
  organization about which a manager seeks cost,
  revenue, or profit data. A segment can be . . .

A Product Line
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Responsibility Centers

• A responsibility center is a segment of an
  organization for which a particular manager is
  responsible.

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Responsibility Centers

• Three Types of Centers
• Expense (or Cost) Centers
• Profit Centers
• Investment Centers

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Expense/Cost Centers

• Incur expenses only
• Produce no direct revenue from sale of goods or
  services
• Manager held responsible for long-run
  minimization of expenses
• Primary means of evaluation
• Standard costs
• Flexible budgets
• e.g., accounting department

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Profit Centers

• Incur expenses and generate revenue
• Primary objective is profit maximization
• Manager is held responsible for expense control
  and revenue growth
• Primary means of evaluation
• Contribution margin
• Why are they so appealing?
• Management is often paid based on how well
  their profit center performs.

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Investment Centers

• What do they have besides expenses and revenues?
• An appropriate investment base
• Objective is to maximize return on that
  investment base
• Primary means of evaluation
• Return on investment (ROI)
• A/K/A Rate of Return
• Residual Income

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Transfer Prices

• The price used to record a transferof goods
  or services from onesegment to another
  segmentwithin the same company.

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Transfer Prices
BuyingSegment
SellingSegment
Revenue
Cost or expense

• What is the primary use for transfer pricing?
• Allows turning a cost center into a profit
  center.

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Transfer Prices
BuyingSegment
SellingSegment
Revenue Higher priceis desired.
Cost or expense Lower priceis desired.
Potentialconflict
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Transfer Prices
BuyingSegment
SellingSegment
Revenue Higher priceis desired.
Cost or expense Lower priceis desired.

• The transfer price can be . . .
• Market price if external market exists
• Cost to produce plus a profit margin
• Negotiated amount

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Transfer Prices
BuyingSegment
SellingSegment
Revenue Higher priceis desired.
Cost or expense Lower priceis desired.

• Setting prices is a big problem in practice.
• Management, marketing and finance courses also
  cover transfer pricing. Each discipline thinks it
  owns the problem.

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Segmental Analysis

• Def. - Analyzing financial information by segment
• Uses concepts previously studied
• Fixed and variable costs
• Contribution margin, net income, etc.
• And new concepts
• Cost objective
• Direct cost
• Indirect cost

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Segmental Analysis ConceptsCost Objective

• Cost objective
• The segment or product for which costs may be
  accumulated
• i.e., a scheme for collecting costs
• KEY - Costs are either direct or indirect
  relative to a particular cost objective.

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Segmental Analysis Concepts Direct Costs

• Specifically traceable to a given cost objective
• Likely to be eliminated if cost objective
  eliminated
• Often controllable by segment manager
• Examples
• Cost accountants salary at Little Rock plant is
  a direct cost for that plant/cost objective
• Corp. accountants salary is direct cost to NY
  accounting department/cost objective

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Segmental Analysis Concepts Indirect Costs

• Allocated to a cost objective and not
  specifically traceable to that objective
• Not likely to be eliminated if cost objective
  eliminated
• Often not controllable by segment manager
• Example
• Corporate accountants salary and the rent on NY
  home office are indirect relative to the three
  plants/cost objectives

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Segmental Analysis Concepts Direct and Indirect
Costs

• Therefore, costs may be direct to one cost
  objective and indirect to another.
• Another example Segment managers salary is
  direct to the segment but indirect to the units
  of product made in that segment.
• Caveat - Some direct costs may not be
  controllable by the segment manager.
• Example Segment managers salary is direct to
  segment but not controlled by the segment
  manager.

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Segmental AnalysisExample
Total Company has two divisions.
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Segmental AnalysisExample
Contribution Margin Format Income
StatementBefore Segmenting into Divisions
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Segmental AnalysisExample
Contribution Margin Format Income StatementAfter
Segmenting into Divisions
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Contribution Margin Format Income Statement

• Emphasizes a segments contribution to indirect
  expenses as appropriate figure for evaluating
  earnings of the segment.
• Expenses are classified as either . . .
• Variable or fixed
• Direct or indirect
• Companies may choose to allocate or not to
  allocate indirect fixed expenses.
• Authors preference?

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Direct and Indirect Costs

• Fixed costs that are direct on one segmented
  statement can become indirect if the segment is
  divided into smaller segments.

Lets see how this works!
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Segmental AnalysisExample
Organizational Segments
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Segmental AnalysisExample
Contribution Margin Format Income
StatementBefore Segmenting TV Division into
Product Lines
TV Divisions 170,000 direct fixed expenses
becomes 140,000 with additional segmentation.
30,000 is indirect to product lines.
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Segmental AnalysisExample
Contribution Margin Format Income
StatementBefore Segmenting TV Division into
Product Lines
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Segmental AnalysisExample
Contribution Margin Format Income StatementAfter
Segmenting TV Division into Product Lines
170,000 is directto TV Division.
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Are you readyfor investmentcenter analysis?
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Investment Center AnalysisReturn on Investment

• Return on investment (ROI) provides a relative
  measure of effectiveness of segments.
• ROI calculates the return (income) as a
  percentage of assets employed (investment).

Skipped in Chapter 17 - Must know now!
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Investment Center AnalysisReturn on Investment

• ROI may be used to evaluate different levels of
  investment centers in a company. (ILL. 25.7, p.
  896)
• Evaluation of earnings of an entire company
• Evaluation of the income contribution of a
  segment
• Evaluation of income performance of a segment
  manager
• Therefore, Income and Investment can be
  defined any of three ways.

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Evaluation of Earningsof Entire Company

• When evaluating an entire company . . .
• Income in ROI formula is net income of company.
• Investment in ROI formula is total assets of
  entire company.

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Evaluation of Income Contribution of Segment

• When evaluating a segment . . .
• Income in ROI formula is contribution to
  indirect expenses.
• Investment in ROI formula is assets directly
  used by and identified with the segment.

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Evaluation of Performanceof Segment Manager

• When evaluating a segment manager . . .
• Income in ROI formula is income that is
  controllable by segment manager.
• Begin with contribution to indirect expenses
  and eliminate any revenues and expenses not under
  the direct control of segment manager.
• Investment is assets under the control of the
  segment manager.

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Expanded Form of ROI Calculation
The ROI formula is expanded into two ratios to
more easily demonstrate actions that might be
taken to increase ROI.
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ROI Question
Regal Company has sales of 500,000, income of
30,000 and investment in assets of 200,000.
What is Regals margin (return on sales)? a.
6 b. 10 c. 12 d. 15
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ROI Question
Regal Company has sales of 500,000, income of
30,000 and investment in assets of 200,000.
What is Regals margin (return on sales)? a.
6 b. 10 c. 12 d. 15
Margin 30,000 500,000 6
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ROI Question

• Regal Company has sales of 500,000, income of
  30,000 and investment in assets of 200,000.
  What is Regals turnover?
• a. 2.0 times
• b. 2.5 times
• c. 3.0 times
• d. 3.5 times

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ROI Question
Regal Company has sales of 500,000, income of
30,000 and investment in assets of 200,000.
What is Regals turnover? a. 2.0 times b. 2.5
times c. 3.0 times d. 3.5 times
Turnover 500,000 200,000 2.5 times
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ROI Question
Regal Company has sales of 500,000, income of
30,000 and investment in assets of 200,000.
What is Regals ROI? a. 6 b. 10 c. 12 d.
15
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ROI Question
Regal Company has sales of 500,000, income of
30,000 and investment in assets of 200,000.
What is Regals ROI? a. 6 b. 10 c. 12 d.
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ROI Margin TurnoverROI 6 2.5 15
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Problems With ROIMeasuring Investment in Assets

• Three Ways To Measure Investment
• Original cost
• Original cost less accumulated depreciation
  (i.e., book value)
• Current replacement cost

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Problems With ROISuboptimization

• Def. - Segment manager takes action in segments
  best interest, but not in best interest of
  company as a whole.
• To deal with suboptimization, companies sometimes
  use Residual Income (RI).
• Residual income is the amount of income a segment
  has in excess of a desired minimum ROI.

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Problems With ROISuboptimization Example
You are a division manager with an annual
salary of 50,000 plus a bonus of 10,000 for
each one percent that your division ROI exceeds
company ROI. Your division ROI is 30 percent
while the company ROI is 15 percent. What is your
current total annual pay?
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Problems With ROISuboptimization Example
You are a division manager with an annual
salary of 50,000 plus a bonus of 10,000 for
each one percent that your division ROI exceeds
company ROI. Your division ROI is 30 percent
while the company ROI is 15 percent. A new
project is available with an ROI of 24 percent.
Based on your compensation plan, would you accept
the project?
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Problems With ROISuboptimization Example
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Problems With ROISuboptimization Example
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Residual Income

• To deal with suboptimization of this type,
  lets use residual income (RI).

RI Income (Investment Minimum ROI)
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Residual Income Question

• A division has a 100,000 investment in assets
  and a company minimum ROI of 20 percent. If
  income for the division is 30,000, what is
  residual income?
• a. 30,000
• b. 20,000
• c. 10,000
• d. 0

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Residual Income Question
A division has a 100,000 investment in assets
and a company minimum ROI of 20 percent. If
income for the division is 30,000, what is
residual income? a. 30,000 b. 20,000 c. 10,0
00 d. 0
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Motivation and Residual Income
Using residual income to evaluate managers
encourages them to make profitable investments
that would be rejected by managers evaluated
using ROI only.
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Motivation and Residual Income
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THE END
Ill teach you a thing or two about
responsibility and authority in my organization!