Hindrances/Problems to Proper Cost Assignment in Segmented Reporting:

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 particular segment or division, then all of the costs attributable to that division or segment–and only those costs–should be assigned to it. Unfortunately, three practices greatly hinder proper cost assignment:

Omission of costs:

The costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain. The value chain consists of major business functions that add value to a company’s products and services. All of these functions, from research and development, through product design, 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 for financial reporting purposes, some companies deduct only manufacturing costs from product revenues. As a result such companies omit from their profitability analysis part or all or the “upstream costs” in the value chain which consist of research and development and product design, and “downstream costs” which consist of marketing, distribution and customer service. Yet these non manufacturing costs are just as essential in determining the product profitability as are the manufacturing costs. These upstream and downstream costs, which are usually titled selling, general and administrative (SG&A) on the income statement, 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 under-costed and management may unwillingly develop and maintain products that in the long run result in losses rather than profits for the company.

Inappropriate methods for allocating costs among segments:

Cross-subsidization, or cost distortion, occurs when costs are improperly assigned among a company’s segment. Cross-subsidization can occur in two ways; first, when companies fail to trace costs directly to segments in those situations where it is a feasible to do so; and second, when companies use inappropriate bases to allocate costs.

Failure to trace cost directly:

Costs that can be traced directly to a specific segment of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example, the rent for a branch office should be charged directly against the branch office rather than included in a company wide overhead pool and then spread throughout the company.

Inappropriate Allocation Base:

Some companies allocate costs to segments using arbitrary bases such as sales dollars or cost of goods sold. For example, under the sales dollars approach, costs are allocated to the various segments according to the percentage of company sales generated by each segment. If a segment generates 20% of total company sales, it would be allocated 20% of the company’s SG&A expenses as its fair share. This same basic procedure is followed if cost of goods sold or some other measure is used as the allocation base. For this approach to be valid, the allocation base must actually drive the overhead cost. Or at least the allocation base should be highly correlated with the cost driver of the overhead cost. For example, when sales dollars is used as the allocation based for SG&A expense, it is implicitly assumed that SG&A expense change in proportion to change in total sales. If that is not true, the SG&A expenses allocated to segments will be misleading.

Arbitrarily dividing common costs among segments:

The third business practice that leads to distorted segment costs is the practice of assigning  non-traceable costs to segments. For example, some companies allocate the costs of the corporate headquarters building to products on segment reports. However, in a multiproducts company, no single product is likely to be responsible for any significant amount of this cost. Even if a product were eliminated entirely, there would usually be no significant 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 corporate headquarters building are necessary, of course, to have a functioning organization. The common practice of arbitrarily allocating these costs to segments is often justified on the grounds that “someone” has to “cover the common costs.” While it is undeniably true that the common costs must be covered, arbitrarily 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 make make an otherwise profitable segment appear to be unprofitable. If a manager erroneously eliminates the segment, the revenues will be lost, the real costs of a segment will be saved, but the common cost will still be there. The net effect will be to reduce the profit of the company as a whole and make it even more difficult to “cover the common costs.” In sum, the way many companies handle segment reporting results in cost distortion. This distortion results from three practices–the failure to trace costs directly to specific segment when it is feasible to do so, the use of inappropriate bases for allocating costs, and the allocation of common costs to segments. These practices are widespread. One study found that 60% of the companies surveyed made no attempt to assign SG&A costs to segments on a cause and effect basis.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

1. Decentralization in organizations
2. Traceable and common fixed costs
3. Segment reporting and profitability analysis-segmented income statements
4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
5. Segmented Financial Information on External Reports
6. Return on Investment (ROI) for Measuring Managerial Performance
7. Controlling and Improving Rate of Return on Investment
8. Return on Investment (ROI) and Balanced Scorecard
9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
10. Residual Income-Another Method to Measure Managerial Performance
11. Limitations, Criticism or Disadvantage of Residual Income Method
12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
13. Set transfer prices at cost using variable or full (absorption) cost
14. Set transfer prices at the market price
15. Divisional Autonomy and Sub optimization
16. International Aspects of Transfer Pricing

Other Related Accounting Articles:

• Segment Reporting and Profitability Analysis – Segmented Income Statements
• Traceable and Common Fixed Costs
• Transfer at Cost to the Selling Division
• Decentralization, Segment Reporting and Transfer Pricing
• Segmented Financial Information on External Reports
• Set Transfer Price at Market Price
• Criticism/Disadvantages or Limitations of Return on Investment (ROI) Method of Performance Evaluation
• Return on Investment (ROI) Method for Measuring Managerial Performance
• Return on Investment (ROI) and Balanced Scorecard
• Decentralization in Organizations