SEGMENT

REPORTING:DECENTRALIZATION

A decentralized organization is where decision

making is spread throughout the organization.
Managers at various levels make key operating
decisions relating to their areas of responsibility.

Total decentralization means minimum constraints

and maximum freedom for managers to make
decisions at the lowest levels of an organization.

Total centralization means maximum constraints

and minimum freedom for managers to make
decisions at the lowest levels of an organization.
Most companies structures fall somewhere in
between these two extremes.

Benefits of Decentralization
1.

2.

Creates greater responsiveness to local needs.

Lower level managers are usually well informed about
their customers, competitors, suppliers, and
employees and other ways to decrease costs and
improve quality. Their decisions are therefore based on
detailed and up to date information about conditions in
their own area of responsibility.
Leads to quicker decision making.
An organization that gives lower-level managers the
responsibility for making decisions can make decisions
quickly, creating a competitive edge over organizations
that are slower because they send their decision
making responsibility upward through layers of
management.

3.

4.

Increases motivation.
Giving responsibility and decision making authority
to lower level managers results in increased job
satisfaction as the job becomes more interesting
and provides greater incentives and motivation. A
company like Johnson and Johnson, a highly
decentralized company, maintains that
Decentralization = Creativity = Productivity.
Aids management development and learning.
Decentralization enables the middle and lower
level managers to gain experience in making
decisions thereby preparing them for higher level
positions.
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5.

6.

Sharpens the focus of managers.

In a decentralized setting, the manager of a small
subunit has a concentrated focus. A small
subunit is more flexible and is better able to adapt
itself quickly to a fast-opening market opportunity
than a larger subunit. Top management are also
relieved of the day to day operations and can
spend more time and energy on strategic
planning for the entire organization.
It is easier to evaluate a managers performance
when he or she has been given a free hand in his
job.

Costs of Decentralization
1.

Leads to suboptimal (also called

incongruent) decision making, which arises
when a decisions benefit to one subunit is
more than offset by the costs or loss of
benefits to the organization as a whole. This
cost arises because top management has
given up some control over decision making.
Suboptimal decision making may occur:

Where there is a lack of harmony or

congruence in the goals set.

When no guidance is given to subunit

managers concerning the effects of their
decisions on other parts of the organization.
2. Results in duplication of activities.
Several individual subunits of the organization
may undertake the same activity separately.
For example, staff functions such as
accounting, employee relations and legal
functions may be duplicated in a highly
decentralized organization. Centralizing these
functions helps to consolidate, streamline and
downsize these activities.

3. Decreases loyalty towards the organization as

a whole.

Individual subunit managers may regard the

managers of other subunits in the same
organization as external parties.
Consequently, managers may be unwilling to
share significant information or to assist when
another subunit faces an emergency.
4. Increases costs of gathering information.

Managers may spend too much time

negotiating the prices for internal products or
services transferred among subunits.
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Decentralization and Segment Reporting

Effective decentralization requires segmental

reporting.
In addition to company wide financial statements,
reports are needed for individual segments of a
company.
A segment is a part of an organization about which
managers would like the cost, revenue or profit data.
These include divisions of a company, sales
territories, individual stores, service centers,
manufacturing plants, marketing departments,
individual customers and product lines.
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Business segments are usually categorized into:

Cost centers manager accountable for costs only
Revenue centers manager accountable for
revenues only
Profit centers manager accountable for revenues
and costs
Investment centers manager accountable for
investments, revenues and costs.

Segment Reporting and Profitability analysis

To evaluate the performance of business

segments, an income statement that
emphasizes segments is used rather than the
performance of the company as a whole.
Segmented income statements can be prepared
for activities at many levels in a company.
The contribution margin format is used to
prepare segmented income statements.

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SALES AND CONTRIBUTION MARGIN

The contribution margin for each segment

shows what happens to profits as volume
changes, holding a segments capacity and fixed
costs constant.
The contribution margin is especially useful in
decisions involving temporary use of capacity
such as special orders.
Decisions concerning the most effective uses of
existing capacity often involve only variable
costs and revenues which are the elements
involved in contribution margin.

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TRACEABLE AND COMMON FIXED COSTS

A traceable fixed cost is a fixed cost that is incurred

because of the existence of the segment-i.e.-if the
segment never existed, the fixed cost would not
have been incurred and if the segment were
eliminated, the fixed cost would disappear.
A common fixed cost is a fixed cost that supports
the operations of more than one segment but is not
traceable in whole or in any part to any one segment
i.e. Even if a segment were entirely eliminated, there
would be no change in a common fixed cost.

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IDENTIFYING TRACEABLE FIXED COSTS

The distinction between traceable and common fixed
costs is crucial in segment reporting, since traceable
fixed costs are charged to the segments, whereas
common fixed costs are not. In actual situations, it is
sometimes hard to determine whether a cost should
be classified as traceable or fixed cost.
Some costs are easy to identify as traceable costs. In
assigning costs to segments, the key point is to resist
the temptation to allocate costs (e.g. Depreciation
costs) that are clearly common in nature and that
would continue regardless of whether the segment
exists or not.
NB: Fixed costs that are traceable to one segment may
be a common cost of another segment.

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SEGMENT MARGIN

Segment margin is obtained by deducting the

traceable fixed costs of a segments contribution
margin. It represents the margin available after a
segment has covered all of its own costs.
It is the best gauge of the long-run profitability of a
segment since it includes only those costs that are
caused by the segment. If a segment cannot cover
its own costs, then that segment probably should
not be retained (unless it has important side effects
on other segments).

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From a decision-making point of view, 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
major decisions relating to short-run changes in
volume, such as pricing special orders that involve
utilization of existing capacity.

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HINDRANCES TO PROPER COST ASSIGNMENT

For segment reporting to accomplish its intended
purposes, costs must be properly assigned to segments.
If the purpose is to determine the profits being generated
by a particular division then all of the costs attributable to
that division only should be assigned to it.
3 business practices greatly hinder proper cost
assignment:Omission of some costs in the assignment process
The use of inappropriate methods for allocating costs
among segments of a company.
Assignment to segments of costs that are really
common costs.
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1. Omission of costs

The costs assigned to a segment should include all

costs attributable to that segment from the
companys entire value chain which consists of the
major business functions that add value to a
companys products and services.

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2. Inappropriate Methods for allocating costs

among segments
Cross-subsidization or Cost Distortion Occurs when
costs are improperly assigned among a companys
segments. This can be in two ways:
Failure to trace costs directly to segments.
Costs that can be traced directly to a specific
segment of a company should be charged directly
to
the responsible segment and not be allocated to other
segments.
E.g. the rent for a branch office of a company should
be charged directly against the branch to which it
relates rather than included in a companywide
overhead pool and then spread throughout the company.

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Use of inappropriate bases to allocate costs.

Some companies allocate costs to segments using
arbitrary bases such as percentage of sales
generated by each segment.

For this approach to be valid, the allocation base

must actually drive the overhead cost, or at least the
allocation base should be highly co-related with the
cost driver of the overhead cost.

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3. Dividing Common costs among Segments

The practice of assigning non-traceable costs to

segments leads to distorted segment costs. E.g. some
companies allocate the costs of the corporate
headquarters building to products on segment reports.
However, in a multi-product company, no single
product is likely to be responsible for any significant
amount of this cost. Even if a product were completely
eliminated, there would be no significant effect on any
of the costs of the corporate headquarters building.
This means 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.
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