ACCT CH 11
*Any allocation of common costs to segments reduces the value of the segment margin
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When a company uses residual income or EVA to measure performance, the objective is to maximize residual income or EVA, NOT ROI
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performance measures used in the balanced scorecard approach tend to fall into four groups:
1. financial 2. customer 3. internal business processes 4. learning and growth
Any increase in ROI must involve one of the following:
1. increased sales 2. reduced operating expenses 3. reduced operating assets
Criticisms of ROI
1. managers may not know how to increase ROI (ROI is best used as part of a balanced scorecard) 2. a manager who takes over a business segment typically inherits many committed costs over which the manager has no control 3. a manager who is evaluated on ROI may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager's performance evaluation
segment margin
CM margin - traceable fixed costs of the segment *best gauge of the long-run profitability of a segment because it includes only those costs that are caused by the segment
*treat traceable costs: only those that would disappear over time if the segment itself disappeared
Ex: if the consumer products division was discontinued it would no longer be necessary to pay the division's managers salary
ROI = Margin x Turnover
Margin = Net Op. Income/Sales Turnover = Sales/Avg. Operating assets
Residual income =
Net Op. Income - (avg. op. assets x minimum required rate of return)
ROI =
Net operating income --------------------------- average operating assets
Traceable fixed cost
a fixed cost that is incurred because of the existence of the segment; if the segment never existed the cost would not have been incurred; and if the segment were eliminated the cost would disappear EX: -salary of Fritos product manager at PepsiCO is traceable to the Fritos business segment of PepsiCo -liability insurance at Disney World is traceable fixed cost of the Disney World business segment of the Disney Coorporation
Economic Value Added (EVA)
an adaptation of residual income that has been adopted by many companies. (*dont worry about the distinction) under EVA, companies can modify their accounting principles in various ways. EX: funds used for research and development are often treated as investments instead of expenses
responsibility center (3 types)
any part of an organization whose manager has control over and is accountable for cost, profit, or investments 1. cost centers 2. profit centers 3. investment centers
the various measures on a balanced scorecard should
be linked on a probable cause-and-effect basis
current assets
cash, accounts receivable, inventories
operating assets
cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes (*NOT land held for future use, investments in another company, or building rented to someone else)
Balanced scorecard
consists of an integrated set of performance measures that are derived from and support the company's strategy under the balanced scorecard approach, top management translates its strategy into performance measures that employees can understand and influence EX: the amt of time passengers have to wait in line to have their baggage checked might be a performance measure for the supervisor in charge of the airlines check-in counter
Operating expenses
cost of goods sold, selling expense, administrative expense
decentralized organization
decision making authority is spread throughout the organization rather then being confined to a few top executives
Common fixed cost
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 a true common fixed cost EX: -salary of the CEO of of General Motors is a common fixed cost of the various divisions of GE -cost of heating a Kroger store is a common fixed cost of the store's various departments (meant, bakery etc) -cost of receptionists salary at an office shared by a number of doctors
margin
improved by increasing sales or reducing operating expenses *lower operating expenses - higher margin
Net operating income
income before interest and taxes and is sometimes referred to as EBIT (earnings before interest and taxes)
turnover
investment in operating assets (excessive funds tied up in operating assets depress turnover and lower ROI)
in essence, the balanced scorecard:
lays out a theory of how the company can take concrete actions to attain its desired outcomes *an integrated system of performance measures designed to support an organizations strategy
responsibility accounting systems
link lower-level managers decision-making authority with accountability for the outcomes of these decisions
Investment center
manager has control over costs, revenue and investments
Residual income
net operating income that an investment center earns above the minimum required return on its operating assets
noncurrent assets
plant and equipment, other assets
Residual income vs ROI
residual income encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using ROI
Divisional segment margins
show company's divisional managers how much their division is contributing to company's profits
Cost center
the manager of a cost center has control over costs but not over revenue or the use of investment funds Ex: accounting, finance, legal, general administration managers are expected to minimize costs while providing the level of products and services demanded by other parts of the organization
Profit Center
the manager of a profit center has control over both costs and revenues, but not over the use of investment funds
segment margin
valuable tool for assessing the long-run profitability of a segment of the company & is a much better tool for evaluating performance than absorption costing income statements