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I'm Larry Walther, this is principlesofaccounting.com,
Chapter 23, and this chapter is about reporting to support managerial decisions.
This particular module is on segment reporting.
A segment is a discreet business unit for
which separate financial information is prepared and
evaluated by the chief operating decision maker within the organization.
So we are disaggregating corporate information and
looking at it by unit of operation.
The decision maker usually has authority to allocate resources and
judge performance.
A segment can be a region, territory, division, product category, department or
any other classification.
This is a highly subjective determination.
The goal however, is to divide or allocate overall performance outcomes to
the various moving pieces that make up the entire entity.
In evaluating segment income,
great care must be taken to develop a very logical structure.
Indirect cost, for example, may be necessary cost for
the overall organization to function.
But there's a question of how they should be allocated to individual segments.
Further, direct cost can become indirect as they are pushed down within
an organization.
It's easy to overlook this facet.
For example, if you share an apartment with a roommate,
the electricity consumed by that apartment is a direct cost for
the apartment, but for each of you individually,
it becomes an indirect cost because you are sharing the electricity bill.
The same issues arise in determining how costs are spread within an organization.
Businesses often develop models for
allocating indirect costs to business units.
The allocation scheme can be the subject of debate and
consternation, as each business unit may feel its profit measurement is
unduly burdened by an unfair share of the indirect costs.
Reporting of segments is often facilitated by some form of
contribution income statement.
It's an internal use only document.
It identifies each segment's controllable cost elements, and costs
that cannot be traced directly to a sub unit are considered only at higher levels.
Let's look at an example to show how this can operate.
Zen Computers is a diversified company with two divisions,
computer hardware, and systems support.
The hardware unit focuses on personal computers, that is, PCs and
personal digital entertainment devices or PDEs, we'll call them.
And so here's their report.
And we can see, we look at the contribution margin for each product and
the division and the aggregate.
The Contribution Margin remember, is sales minus all variable costs,
whether it's variable product cost or variable SG&A.
>From that amount we will subtract controllable fixed cost, that is,
costs that are controllable by management of that segment and directly traced to
that segments, such as the supervisor's salary within that segment.
We'll subtract those to find a controllable contribution margin.
And that's a key number in evaluating management performance for
an applicable unit.
We'll also subtract certain uncontrollable fixed costs that may not be controllable
by management but are definitely incurred by the segment.
An example would be property taxes or insurance, for example.
Subtracting those amounts gives us the segment margin.
For PCs, for PDEs, and for the division, there were certain non-traceable costs.
Non-traceable items are directly traced to the overall division,
not individual products, and so we're not allocating the others to the PCs or PDEs.
The division total is going to be carried forward into a successively higher
aggregation report that we'll see in just a moment.
But first consider that segment margins were computed for each product,
that helped identify if each product is supporting its embedded cost structure.
Segment margin differs from the controllable contribution margin.
Management is charged with controlling certain costs,
a business unit may incur additional fixed costs that are beyond their control.
That's why we break this out in our segment income statement as we've done.
And uncontrollable fixed costs must be considered in evaluating unit viability,
but not necessarily in assessing the performance of a particular manager.
So those are two discrete elements that need to be evaluated.
Management effectiveness, as well as the unit's viability.
Now, here is the roll-up.
So I've shaded the hardware division.
That's just a roll forward of the information from the preceding
combinations of PCs and PDEs.
We'll have similar items, we'll calculate the contribution margin and
take into account our other elements, adding across, to get the company total.
But notice the segment margin was $5,400 for hardware.
It was 1500 for Systems.
But there are still General Corporate expenses that we need to subtract
in finding the overall net income for the business.
The General Corporate expenses we do not trace or assign to a particular division.
The point of the case study was to show how contribution income statements
can remove bias that can result from arbitrary allocations of common cost.
It is also sometimes helpful in identifying which business segments
are targets for expansions, restructuring or even discontinuing.
Occasionally, a business may report external information about segment
performance.
This is actually driven by a very specific generally accepted
accounting principles and rules.
However, before I get into that, I wanna point out that management may be
reluctant to share this disagregated information.
They may not want to attract the competition of a competitor where
they have particularly strong performing units.
On the other hand, they may not want to call attention to their mistakes either,
they may rather mask this.
That's why GAAP gets into having a full disclosure of certain segment information.
And so the reporting rules require public companies to present a limited
amount of information for each business segment.
This generally consists of revenue, income, and
identifiable assets in use by each significant segment of the business.
There are specific mathematical tests for determining, generally 10% type tests for
determining when a segment's revenue is significant separately,
as compared to the total organization.
Similarly for operating profits and assets in use by the business.
There's a reconciliation of the corporate totals and it might look like this.
This example is repeated in your textbook, so you can see it and
look at it in more detail if you wish.
Here's a business that has an electrical product segment and
a galvanizing services segment.
And we're not going to look at the specific details here
except to note that we do have sales for each segment.
We have our operating income for each segment and we're dropping down and
showing total assets in use by each segment.
I've skipped over that middle part there which is the reconciliation of segment
income to total corporate income,
which takes into account general corporate expenses, interest costs, and so forth.
Businesses will also need to report information about depreciation and
amortization in capital expenditures by significant segments.
And so, a fairly robust set of information,
maybe not as detailed as the internal information we looked at.
Maybe following a little bit different classification scheme, but
still giving sufficient information to allow users of financial statements to
look inside, beyond just the consolidated results reported by the business, but
to look inside the business and see how specific business units are performing.
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