Managerial Accounting Chapter 6

Levels of Segmented Income Statements

see pg 247-9 in textbook

Decision Making

see pg 249

omission of Costs

the costs assigned to a segment should include all costs attributable to that segment from the company's entire value chain -All of these functions, from research and development, through product desing, 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 under absorption costing, which is widely regarded as required for external financial reporting To avoid having to maintian two costing systems and to provide consistency between internal and external reports, many comapnies also use absorption costing for their internal reports such as segmented income statements As a result, such companies omit from their profitabiltiy analsis part of all of the "upstream" costs in the value chain, which consist of research and development and rpoduct design, and the "downstream" costs which consist of marketing, distribution, and customer service -yet these nonmanufacturing costs are just as essential in determining product profitability as are the manufacturing costs -these upstream and downstream costs, which are usually included in selling and administrative expenses on absorption costing income statements, 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 undercosted and management may unwittingly develop and maintain products that in the long run can result in losses.

To prepare a segmented income statement

variable expenses are deducted from sales to yield the contribution margin for the segment The contribution margin tells us what happens to profits as volume changes- holding a segment's capacity and fixed costs constant The contributon margin is especially useful in decisions involving temporary uses of capacity such as special orders. These types of decisions often inolve only variable costs and revenues- the two components of contribution margin

Traceable Costs can Become Common Costs

Fixed costs that are traceable to one segment may be a common cost of another segment

Companywide Income Statements

Absorption costing is required for external reports according to US generally accepted accounting principles International Financial Reporting Standards explictily require companies to use absorption costing -probably because of the cost and possible confusion of maintaining two sepearte costing systems- one for external reporting and one for internal reporting- most companies use absorption costing for their external and internal reports With all of the advances of the contribution approach, you may onder why the absorption appraoch is sued at all - While the answer is partly due to adhering to tradition, absorption costing is also attractive to many accontants and managers because they believe it better matches costs with revenues Advocates of absorption costing argue that all manufacturing costs must be assigned to products in order to properly match the costs of producing units of product with their revenues when they are sold -the fixed costs of depreciation, taxes, insurance, supervisory salaries, and so on, are just as essential to manufacuting products as are the variable costs advoactes of variable costing argue that fixed manufacturing costs are not really the costs of any particular unit of product -these costs are incurred to have the capacity to make products during a particular period and will be incurred even if nothing is made druing the period -moreover, whether a unit is made or not, the fixed manufacturing costs will be exactly the same -therefore, variable costing advocates argue that fixed manufacturing costs are not part of the costs of producing a particular unit of prduct, adn thus, the matching principle dictates that fixed manufacturing costs should be charged to the current period

Segmented Income Statments- Common Mistakes

All of the costs attribuatble to a segment- and only those costs- should be assigned to the segment Unfortunately, companies often make mistakes when assigning costs to segments -They omit some costs, inapporpiately assign traceable fixed costs, and arbitrarily allocate common fixed costs

Failure to Trace Costs Directly

Costs that can be traced directly to a specific segment should be charged directly to that segment and should not be allocated to other segments

Break Even Analysis

Dollar sales for company to break even= Traceable fixed expenses + Common fixed expenses/ Overall Cm ratio Dollar sales for a company to break even: Segment traceable fixed expenses/ Segment CM ratio Segement break even calculations do not include the company's common fixed expenses In an attempt to "cover the company's common fixed epenses" managers will often allocate common fixed expenses to business segments when preforming break-even calculations and making decisions. This is a mistake! -Allocating common fixed expenses to business segments artificially inflates each segment's break-even point. This may cause managers to erroneously discontinue business segments where the inflated break-even point appears unobtainable -the decision to retain or discontinue a business segment should be based on the sales and expenses that would disappear if the segment were dropped. Because common fixed expenses will persist even if a business segment is dropped, they should not be allocated to business segments when making decisions.

Common Fixed Cost

Fixed Cost that supports the operations of more than one segment, but is not tracebale 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 Examples: - The salary of the CEO of General Motors ia common fixed cost of the various divisions of General Motors - The cost of heating a Safeway or Kroeger grocery store is a common fixed cost of the store's various deparmtnets- groceries, produce, bakery, meat, and so forth The cost of the receptionist's salary 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 individual cdoctors

Traceable Fixed Cost

Fixed cost that is incurred because of the existence of the segment- if the segment had never existed teh fixed cost would not have been incurred; and if the segment were eliminated, the fixed cost would disappear Examples: - the salary of the Fritos product manager at PepsiCO is a traceable fixed cost of the Fritos business segment of PepsiCo -The maintenance cost for the building in which Beoings 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing - The liability insurance at Disney World is a traceable fixed cost of the Disney World business segment of the Walt Disney Corporation

Inapporiate Methods for Assigning Traceable Costs among Segments

In addition to omitting costs, many companies to not correctly hadnle traceable fixed expenses on segmented income statments First, they do not trace fixed expenses to segmetns even when it is feasible to do so Second, they use inappropriate allocation bases to allocate traceable fixed expenses to segments

Inappropriate Allocation Base

Some companies use arbitrary allocation bases to allocate costs to segments. The same basic procedure is followed if cost of goods sold or some other measure is used for the allocation base Costs should be allocated to segments for internal decision-making purposes only when the allocation base actually drives the cost being allocated (or is very highly correlated with the real cost driver) To the extent that selling and adminstrative expenses are not driven by sales volume, tehses expenses will be improperly allocated- with a disportionately high percentage of the selling and administrative expenses assigned to the segments with the largest sales

Identifying Traceable Fixed Costs

The distinction between traceable and common fixed costs is crucial in segment reporting because traceable fixed costs are charged to segments and common fixed costs are not -in an actual situation, it is sometimes 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 When assigning costs to segments, the key point is to resist the temptation to allocate costs *such as depreciation of corporate facilities) that are clearly common and that will continue regardless of whether the segment exists or not Any allocation of common costs to segments reduces the value of the segment margin as a measure of long-run segment profitability and segment performance

Arbitrarily Dividing Common Costs Among Segments

The third business practice that leads to disorted segment costs ithe practice of assinging nontraceable costs to segments For example, some companies allocate the common costs of the corporate headquarters building to products on segment reports -however, in a mutliprodut company, no single product is likely to be responsible for any significant maount of this cost -even i a product were eliminated entirely, there would usually be o signfiicant effect on any of the costs of the corporate headquarters building -in short, there is no cause-and-effect relation 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 Common costs like the costs of the corporate headquarters building are necessary to have a functioning organization The practice of arbitrarily allocating common costs to segments is often justified on the grounds that "someone" has to "coer the common costs" -while it is undeniabily true that a company must cover its common coststo ear a profit, arbitraily 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 may make an otherwise profitable segment appear to be unprofitable If a manger eliminates the apparently unprofitable segment, the real traceable costs of the segment will be saved, but its revenues will be lost And what happens to the common fixed costs that were allocated to the segment? -They don't disappear; they are reallocated to the remaining segments of the company -that makes all of the remaining segments appear to be less profitable- possibly resulting in dropping other segments -the net effect will be to reduce the overall profits of the company and make it even more difficult to "cover the common costs" Common fixed costs are not manegable by the manager to whom they are arbitrarily allocated; they are the responsibility of higher-level managers When common fixed costs are allocated to managers, they are held responsible for those costs even though they cannot control them

Segmented Financial Information

US GAAP and IFRS require that publicly traded companies include segmented financial and other data in their annual reports and that the segmented reports prepared for external users must use the same methods and definitions that the companies use in internal segmented reports that are prepared to aid in making operating decisions -this is a very unusual stipulation because companies are not ordinarily required to report the same data to external users that are used for internal decision-making purposes -this requirement creates incentives for publicly traded comopanies to avoid using the contribution format for internal segmented reports -segmented contribution format income statements contain vital information that companies are often very reluctant to release to the public (and hence competitors) - in addition, this requirement creates problems in reconciling internal and xternal reports

Segment Margin

obtained by deducting the traceable fixed costs of a segment from the segment's contribution margin Represents the margin available after a segment has covered all of its own costs The segmenet margin is the best guage of the long-run profitability of a segment because it includes only those costs that are caused by the segment IF a segment can't cover its own costs, then that segment probably should be dropped (unless it has important side effects on other segments) Common fixed costs are not allocated to segments From a decision making POV, the segment margin is most useful in major decisions that affect capacity such as dropping a segment By contrast, the contribution margin is most useful in decisions involving short-run changes in volume, such as pricing special orders that involve temporary use of existing capacity