Revised Summer 2010

CHAPTER 10
SEGMENT REPORTING,
DECENTRALIZATION AND THE
BALANCED SCORECARD

Key Terms and Concepts to Know

Organizations:
Centralized and decentralized organizations
Business segments include cost centers, profit centers and investment centers.

Decentralization:
The delegation of decision-making to lower levels of management. It is not
possible for all decisions to be made by top management, especially in large and
medium sized organizations.
Responsibility accounting systems link decision-making authority with
accountability for the outcomes of those decisions.
Large and medium sized organizations are often divided into three types of
responsibility centers: cost centers, profit centers and/or investment centers:
o Cost Centers which may be evaluated through variance analysis
o Profit Centers which may be evaluated by comparing actual income to
budgeted income
o Investment Centers which may be evaluated using Return on Investment or
Residual Income

Fixed Costs:
Traceable fixed costs are incurred for the benefit of one business segment and are
controllable by the segment
Common fixed costs are incurred for the benefit of more than one segment and
are not traceable to or controllable by any one segment.
There are numerous approaches to the allocation of common fixed expenses to
business segments
Problems caused by arbitrarily dividing common costs among segments

Segment Performance Evaluation:

Segment Income Statement
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Return on Investment (ROI) method
Residual Income method

Key Topics to Know

Evaluation of Management Performance

Managers of the cost centers, profit centers and/or investment centers are held
responsible for the results of their particular segment. This is referred to as
responsibility accounting.
Each segment may prepare a Segment Income Statement income statement
which reports the revenue, variable expenses, contribution margin and traceable
fixed expenses controllable by segment management. The highlight of the
segment income statement is the Segment Margin, computed as segment
contribution margin less the segment’s traceable fixed costs. It represents the
segment’s income after all the traceable fixed costs have been covered. Some
companies then deduct the segment’s share of common or allocated fixed
expenses to calculate the segment’s operating income.
In addition to the segment income statement, segment performance may be
evaluated using either Return on Investment or Residual Income.

Return on Investment

ROI measures the segments ability to utilize its operating assets to generate
income. ROI focuses on how efficiently the assets are used since it expressed as
a percent of the assets used. The ability to generate income by utilizing operating
assets varies widely by industry and by company within an industry.
Return on Investment (ROI) has three interrelated formulas:

Net operating income

ROI =
Average operating assets

ROI = Margin X Turnover

Net operating income Sales

ROI = X
Sales Average operating assets

Margin = Net Operating Income / Sales or the ability to keep a portion of sales
dollars in the business as income
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Turnover = Sales / Average Operating Assets or the ability to use operating
assets to generate sales
ROI may be improved in several ways:
o Reduce expenses which increases operating income
o Increase sales which increases operating income
o Reduce operating assets
o Increase operating assets to increase sales which increases operating
income
Net Operating Income, NOT Net Income, is used in the ROI formula. Net
operating income is income before interest and taxes.
Operating assets include cash, accounts receivable, inventory, plant and
equipment and all other assets held for operating purposes. It does NOT include
investments in other companies, land held for future use, or a building that may
be rented to others as opposed to being used in the business.

Example #1:
Montana Company has reported the following results for last year’s operations:

Sales $50,000,000
Net operating income 6,000,000
Average operating assets 20,000,000

Required:
a) Compute Montana’s margin, turnover, and ROI
b) Management has set a minimum required rate of return on average
operating assets of 25%. What is the residual income for the year?

Solution #1:
Net operating income $6,000,000
Margin = = 12%
Sales $50,000,000

Turnover = Sales $50,000,000

= 2.5
Average operating assets $20,000,000

ROI = Margin X Turnover 12% X 2.5 = 30%

Average operating assets $20,000,000

Minimum rate of return 25%
Minimum required income $5,000,000
Net operating income $6,000,000
Residual Income $1,000,000

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Example #2:
Omaha Company provides the following information:

Sales $4,000,000
Net operating income 400,000
Average operating assets 1,600,000

Consider each question independently. Carry out all computations to two decimal
places.

Required:
a) Compute the company’s return on investment.
b) The owner is convinced that sales will increase next year by 150% and that
net operating income will increase by 100%, with no increase in average
operating assets. What would be the company’s ROI?
c) The chief financial officer of the company believes a more realistic scenario
would be a $1,000,000 increase in sales, requiring a $400,000 increase in
average operating assets, with a resulting $250,000 increase in net
operating income. What would be the company’s ROI in this situation?

Solution #2:
Net operating income $400,000
a) ROI = = 25%
Average operating assets $1,600,000

Net operating income $400,000 + 400,000

b) ROI = = 50%
Average operating assets $1,600,000

Net operating income $400,000 + 250,000

c) ROI = = 32.5%
Average operating assets $1,600,000 + 400,000

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Example #3:
Snickers Company has two investment centers and has developed the following
information:
Department A Department B
Net operating income $120,000 ?
Average operating assets ? $400,000
Sales 800,000 250,000
ROI 10% 12%

Required:
a) What was the amount of Department A's average operating assets?
b) What was the amount of Department B's net operating income?
c) If Department B is able to reduce its operating assets by $100,000, what
would be Department B's new ROI?
d) If Department A is able to increase its net operating income by $60,000 by
reducing expenses, what would be Department A's new ROI?

Solution #3:
a) Net operating assets $120,000 =$1,200,000
ROI 10%

b) Average operating assets X ROI $400,000 X 12% = $48,000

c) Net operating income $48,000

= 16%
Net operating assets $400,000 – 100,000

d) Net operating income $120,000 + 60,000

= 15%
Net operating assets $1,200,000

Residual Income:

An alternative measurement tool to ROI is Residual Income, which focuses on the

ability of operating assets to generate dollars of income, not how efficiently the
operating assets were used.
Residual income is the amount by which actual operating income exceeds the
minimum required income.
Minimum Required Income = Required Rate of Return X Average Operating
Assets
Residual Income = Net Operating Income minus Minimum Required Income

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Residual income method has a natural bias in favor of segments with large
operating asset bases since the more assets that are used, the easier it is to
generate operating income and therefore residual income.
Net Operating Income, NOT Net Income, is used in the residual income method.
Net operating income is income before interest and taxes.
Operating assets include cash, accounts receivable, inventory, plant and
equipment and all other assets held for operating purposes. It does NOT include
investments in other companies, land held for future use, or a building that may
be rented to others as opposed to being used in the business.

Example #4:
Snickers Company has two investment centers and has developed the following
information. Snickers Company expects a minimum return on operating assets of 10%.

Department A Department B
Net operating income $120,000 $48,000
Average operating assets $1,200,000 $400,000
Sales 800,000 250,000

Required: What was the amount of residual income for each department?

Solution #4:

Department A Department B
Average operating assets $1,200,000 $400,000
Minimum rate of return 10% 10%
Required operating income $120,000 $40,000
Net operating income $120,000 $48,000
Residual income $0 $8,000

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Practice Problems
Practice Problem #1:
Stockholm Company produces and sells two packaged products, Product W and Product
Z. Revenue and cost data relating to the two products is as follows: and in addition
common fixed expenses not traceable in the company total $44,000 per year. Last year
the company produced and sold 18,000 units of Product W and 30,000 units of Product
Z. The selling price of W is $8 per unit and the selling price of Z is $12 per unit.
Variable expenses of W are $5.50 per unit and Z $8.75 per unit. Traceable fixed
expenses per year are $15,000 for W and $65,000 for Z.

Required: Prepare a contribution format income statement segmented by product lines.

Practice Problem #2:

Madison Company Electronics Division provided the following annual data for 2009:

Sales $8,000,000
Net operating income 1,000,000
Average operating assets 4,000,000

Required: Compute the margin, turnover and return on investment (ROI).

Practice Problem #3:

During 2009 Lansing Company had net operating income of $1,500,000 with sales of
$4,000,000. The company’s average operating assets for the year were $8,000,000 and
its minimum required rate of return was 15%.

Required: Compute the company’s residual income for 2009.

Practice Problem #4:

Lafayette Company has 3 divisions: X, Y, and Z. Compute the missing amounts below.

X Y Z
Sales A 80,000 G
Net operating income B 20,000 6,000
Average operating assets 100,000 D H
Margin 4% E 7%
Turnover 5 F I
ROI C 20% 14%

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Practice Problem #5:
The Homer Company manufactures basketballs. Last year’s sales were $700,000, net
operating income was $100,000, and average operating assets were $800,000.

Required:
a) If next year’s sales remain the same as last year and expenses and average
operating assets are reduced by 10%, what will be the return on investment
next year?
b) If the minimum required rate of return is 6%, what will be the residual
income next year?

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Sample True / False Questions

1. A legal services department would be an example of a cost center.
True False

2. In a decentralized organization, lower-level managers are given a great deal of

autonomy in decision-making.
True False

3. A profit center manager often also supervises revenue and cost center managers.
True False

4. The most common method of evaluating a profit center manager is the

segmented income statement.
True False

5. Investment center managers have control over the investment of assets.

True False

6. Segment margin and operating income are identical terms.

True False

7. Turnover is defined as the ratio of sales revenue to average invested assets.

True False

8. Margin is defined as the ratio of sales revenue to operating income.

True False

9. All other things the same, if a division's traceable fixed expenses decrease the
division's segment margin will increase.
True False

10. The Legal Department of an organization is not considered a responsibility center

because it does not generate revenue.
True False

11. All other things the same, a decrease in average operating assets will increase
return on investment (ROI).
True False

12. Return on investment (ROI) may not be fully controllable by a manager because
of committed costs.
True False

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13. When used in return on investment (ROI) calculations, operating assets include
investments in land held for future use and investments in other companies.
True False

14. Residual income is primarily useful because it helps to compare the performance
of divisions of different sizes.
True False

15. A balanced scorecard is an integrated set of performance measures that should be

designed to support management's strategy throughout the organization.
True False

16. A decentralized organization is one in which decisions are made by top

management and then implemented by managers at lower operating levels.
True False

17. An investment center is any responsibility center in an organization that controls

cost and revenues and invested funds.
True False

18. The same cost can be traceable or common depending on how the segment is
defined.
True False

19. In general, common fixed costs should be assigned to segments.

True False

20. If a company eliminates a segment of its business, the costs that were traceable
to that segment should disappear.
True False

21. If four segments share $800,000 in common fixed costs and one segment is
eliminated, the common fixed costs will decrease by $200,000.
True False

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Sample Multiple Choice Questions

1. In what type of organization is decision-making authority spread throughout the
organization?
a) Centralized organization
b) Decentralized organization
c) Participative organization
d) Top-down organization

2. Which of the following is NOT an advantage of decentralization?

a) Allows top managers to focus on strategic issues
b) Potential duplication of resources
c) Allows for development of managerial expertise
d) Managers can react quickly to local information

3. Which of the following is the primary tool used by cost centers to manage costs?
a) Return on investment
b) Budgetary control system
c) Balanced scorecard
d) Transfer pricing

4. The responsibility center in which the manager does not have responsibility and
authority over revenues is
a) a cost center
b) an investment center
c) a profit center
d) a revenue center

5. The responsibility center in which the manager has responsibility and authority
over revenues, costs and assets is
a) a cost center
b) an investment center
c) a profit center
d) a revenue center

6. The responsibility center in which the manager has responsibility and authority
over only revenues and costs is
a) a cost center
b) an investment center
c) a profit center
d) a revenue center

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7. Which of the following statements follows from the controllability principle?
a) A profit center manager should be evaluated based on residual income, not
return on investment
b) An investment center manager should be evaluated based on return on
investment, not residual income
c) A profit center manager should be evaluated based on segment margin, not
operating income
d) A cost center manager should be evaluated on costs and revenues, not just
costs

8. Return on investment can be calculated as

a) ROI = sales revenue/average invested assets
b) ROI = operating income/sales revenue
c) ROI = operating income/average invested assets
d) ROI = average invested assets/sales revenue

9. Profit margin can be calculated as

a) Sales revenue/average invested assets
b) Operating income/sales revenue
c) Operating income/average invested assets
d) Average invested assets/sales revenue

10. Investment turnover can be calculated as

a) Sales revenue/average invested assets
b) Operating income/sales revenue
c) Operating income/average invested assets
d) Average invested assets/sales revenue

11. Ann Arbor Company has an operating income of $120,000 on revenues of

$1,000,000. Average invested assets are $600,000, and Ann Arbor has an 8%
minimum rate of return. What is the return on investment?
a) 8%
b) 10%
c) 12%
d) 20%

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12. Ann Arbor Company has an operating income of $200,000 on revenues of
$2,000,000. Average invested assets are $500,000 and Ann Arbor Company has
an 8% minimum rate of return. What is the profit margin?
a) 8%
b) 10%
c) 12%
d) 20%

13. Champaign In has revenues of $750,000 resulting in an operating income of

$105,500. Average invested assets total $750,000. Return on investment is
a) 7%
b) 14%
c) $37,500
d) $15,000

14. Champaign In has revenues of $3,000,000 resulting in an operating income of

$210,000. Average invested assets total $375,000. The profit margin is
a) 7%
b) 14%
c) 2.00
d) 0.50

15. Minneapolis Corp. has an ROI of 10% and a residual income of $10,000. If
operating income equals $20,000, what is average invested assets?
a) $200,000
b) $66,667
c) $450,000
d) $150,000

16. Iowa City In has a profit margin of 12% and an investment turnover of 2.5. Sales
revenue is $600,000. What is the operating income?
a) $180,000
b) $28,800
c) $72,000
d) $240,000

17. Iowa City In has a profit margin of 12% and an investment turnover of 2.5. Sales
revenue is $600,000. What is average invested assets?
a) $240,000
b) $1,500,000
c) $50,000
d) $72,000

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18. Bloomington In has a profit margin of 14% and an investment turnover of 2.
Sales revenue is $800,000. What is the operating income?
a) $224,000
b) $56,000
c) $112,000
d) $400,000

19. Bloomington In has a profit margin of 14% and an investment turnover of 2.

Sales revenue is $800,000. What is average invested assets?
a) $240,000
b) $400,000
c) $112,000
d) $224,000

20. Columbus Corp. has revenues of $1,500,000 resulting in an operating income of

$105,000. Average invested assets total $750,000. Calculate the ROI if sales
increase by 10% and the profit margin remains constant.
a) 7.7%
b) 14%
c) 15.4%
d) 7.0%

21. Columbus Corp. has revenues of $1,500,000 resulting in an operating income of

$105,000. Average invested assets total $750,000. If sales increase by 10% and
the investment level remains constant, what is the investment turnover?
a) 2.00
b) 2.20
c) 7.0%
d) 7.7%

22. Urbana Corp. has sales revenue of $500,000 resulting in operating income of
$54,000. Average invested assets total $600,000, and the cost of capital is 6%.
Calculate the return on investment if sales increase by 10% and the profit margin
and invested assets remain the same.
a) 9.0%
b) 9.9%
c) 10.8%
d) 6.0%

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23. If the ROI of a project is greater than the minimum required rate of return, the
residual income will be
a) equal to operating income
b) greater than zero
c) greater than operating income
d) greater than average invested assets

24. Beegeorge Corp. has an operating income of $107,000, average invested assets
of $700,000, and a minimum required rate of return 7%. What is the residual
income?
a) $100,000
b) $166,667
c) $42,000
d) $58,000

25. Evanston Corp. has revenues of $500,000 resulting in an operating income of

$54,000. Invested assets total $600,000. Residual income is $18,000. Calculate
the new residual income if sales increase by 10% and the profit margin and
invested assets remain the same.
a) $23,400
b) $0
c) $3,240
d) $36,000

26. Which of the following is not a limitation of return on investment?

a) Use of ROI may lead to goal incongruence.
b) ROI is a lagging indicator of financial performance.
c) ROI evaluates the short-term.
d) ROI is a commonly used measure for financial performance.

27. LaFayette has a profit margin of 16% based on revenues of $400,000 and an
investment turnover is 2. What is the residual income when the minimum
required rate of return is 10%?
a) $44,000
b) $20,000
c) $40,000
d) $64,000

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28. Samson Corp. has revenues of $500,000 resulting in an operating income of
$54,000. Invested assets total $600,000, the cost of capital is 6%. Calculate the
increase in residual income if sales increase by 10% and the profit margin and
invested assets remain the same.
a) $5,400
b) $24,000
c) $0
d) $7,500

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Solutions to Practice Problems

Practice Problem #1
W Z Total
Sales $ 144,000 $ 360,000 $ 504,000
Variable Expenses 99,000 262,500 361,500
Contribution Margin 45,000 97,500 142,500
Traceable Fixed Expenses 15,000 65,000 80,000
Product Segment Margin $ 30,000 $ 32,500 62,500
Common Fixed Expenses 44,000
Operating income $18,500

Practice Problem #2

Net operating income 1,000,000

Margin = = = 12.5%
Sales 8,000,000

Sales 8,000,000
Turnover = = = 2.0
Average operating assets 4,000,000

ROI Margin X Turnover = 12.5% X 2.0 = 25.0%

Practice Problem #3

Average operating assets $8,000,000

Minimum rate of return 15%
Minimum required income $1,200,000
Net operating income $1,500,000
Residual Income $300,000

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Practice Problem #4:

In the order solved:

C Margin X Turnover 4% X 5 = 20%
B ROI X Average operating assets 20% X $100,000 = $20,000
A Net operating income / Margin $20,000 / 4% = $500,000

E Net operating income / Sales $20,000 / $80,000 = 25%

F ROI / Margin 20% / 25% = .80
D Sales / Turnover $80,000 / 1 = $100,000

I ROI / Margin 14% / 7% = 2

H Net operating income / ROI $6,000 / 14% = $42,857
G Net operating income / Margin $6,000 / 7% = $85,714

Practice Problem #5:

Last Year Change Next Year
ROI:
Net operating income $100,000 $60,000 $160,000
= 22.2%
Average operating assets 800,000 (80,000) 720,000

Change in Income:
Sales $700,000
Net operating income 100,000
Expenses 600,000
Decrease % 10%
Decrease in expenses $60,000 = Change in income

Residual Income:
Average operating assets $800,000 720,000
Minimum rate of return 6% 6%
Minimum required income $48,000 $43,200
Net operating income $100,000 $160,000
Residual Income $52,000 $ 116,800

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Solutions to True / False Problems

1. True
2. True
3. True
4. True
5. True
6. False because segment margin does not include common fixed expenses which
are not traceable to a particular segment.
7. True
8. False because margin is the ratio of operating income to sales revenue.
9. True
10. False because the Legal Department is a responsibility center. It is a cost
center. Each segment does NOT have to generate revenue.
11. True
12. True
13. False because operating assets do NOT include investments in land held for
future use and investments in other companies. These are not part of
operating assets. Operating assets may be described as assets which are
necessary to carry on the day to day activities of a business.
14. False because residual income is the excess of income over a stated minimum
return. It is not useful in comparing various divisions
15. True
16. False because a decentralized organization is one in which decisions are made
by managers at lower operating levels and implemented by those managers.
17. True
18. True
19. False because common fixed costs should NOT be assigned to segments.
These are costs that are incurred for the benefit of the entire organization and
NOT easily traceable to any one particular segment.
20. True
21. False because common fixed expenses should NOT be affected by the
elimination of one segment. No decrease would be expected.

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Solutions to Multiple Choice Questions

1. B
2. B
3. B
4. A
5. B
6. C
7. C
8. C
9. B
10. A
11. D
12. B
13. B
14. A
15. A
16. C
17. A
18. C
19. B
20. C
21. B
22. B
23. B
24. D
25. A
26. D
27. A
28. A

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