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- 1. Responsibility Centers Saalimsadique shaikh 1 www.managementvikalp.co.in
- 2. What is aResponsibility Center? The Responsibility is the unit in the organization that has control over costs, revenues, or investment funds. Responsibility center is an entity, held accountable for an activity/function under consideration, that becomes its objective/goal Organization can be looked upon as collection of responsibility centers. Each RC consumes certain amount of resources “INPUTS” and produces certain results “OUTPUT” Best option to assess the performance of RC starts with establishing relationship among INPUT and OUTPUT and then 2 wwwa.pmapnalgyeminengtv ikiatl ps.cco.rinupulously
- 3. Responsibility Centers furtherdefined It is an organization unit for which a manager is made responsible. The center’s manager and supervisor establish specific and measurable goals for the responsibility center. The goals should promote the long-term interest of the organization. 3 www.managementvikalp.co.in
- 4. The basic definitionof a responsibility center Lowest organizational level at which funds control functions are carried out. Generally the same as divisions in an operating component. 4 www.managementvikalp.co.in
- 5. For accounting purposes,responsibility centers have four classifications: Revenue Centers Cost Centers Profit Centers Investment Centers 5 www.managementvikalp.co.in
- 6. 6 Responsibility Centers- 1. Revenue Center - Prime concern of the REVENUE CENTER – “TOPLINE” e.g. Marketing center Inputs (Money directly spent on achieving sales i.e. Mktg. Exp.) Output (Sales Generated in money terms) RC’s TASK Generate Sales • RC has no authority to decide price. • RC is charged with cost of Marketing and not with cost of goods produced • No formal relationship possible between I & O • Performance Measure for the RC can be Revenue Budgets. www.managementvikalp.co.in
- 7. Revenue Center ARevenue Center is responsible for selling an agreed amount of products or services. It's manager is usually responsible to maximize revenue given the selling price (or quantity) and given the budget for personnel and expenses. 7 www.managementvikalp.co.in
- 8. 8 Revenue Center- Issues Decision Rights – Promotion Mix – Performance Measures – Maximize total sales for a given promotion budget Actual sales in comparison with budgeted sales Typically used when – RC manager has thorough knowledge about market Promotion plays significant role in generating sales RC manager can establish optimal promotion mix He can set optimal quantity and appropriate rewards www.managementvikalp.co.in
- 9. 2. Expense/Cost Centers Responsibility centers whose employees control costs, but Do not control their revenues or investment level. Examples: Production department in a manufacturing unit, a dry cleaning business Two types of costs: Engineered: those costs that can be reasonably associated with a cost center – direct labor, direct materials, telephone/electricity consumed, office supplies. Discretionary: where a direct relationship between a cost unit and expenses cannot be reasonably made; Management allocates them on a discretionary basis (e.g. depreciation expenses for machines utilized).
- 10. 10 Cost/Expenses Center: Engineered Expenses V/s Discretionary Expenses e.g. Manufacturing a product Can be established scientifically Cost varies with even small fluctuations in volume Control is easier. Control starts with planning & ends with finished task. Financial Performance measure suffice the purpose of evaluation. e.g. R&D Project Can not be established scientifically Costs varies with bigger volume changes Review of task is the only control measure for cost control. Control is exercised during planning stage itself, by way of establishment of budget Financial as well as non financial Performance measure need to be considered www.managementvikalp.co.in
- 11. 11 Cost Center Inputs (Money spent on production) Decision Rights – RC’s TASK Input Mix – Labor, Material, Supplies Performance Measures – Minimize total cost for a fixed output Maximize output for a given “cost budget” Typically used when – Output (Physical units Produced) RC manager can measure output & quality of output knows cost functions, optimal input mix can set optimal quantity and appropriate rewards www.managementvikalp.co.in
- 12. 12 2. ExpensesCenter – 2.1)Engineered Exp. Center e.g. Production Department Engineered expenses are those expenses which are arrived at with reasonable reliability.e.g. Material cost , labor cost. Inputs (Money spent on production) Output (Physical units Produced) RC’s TASK • Performance Measure for the RC is std.cost: - Std Cost of doing actual activity = Std. cost of unit activity * Quantum of Actual activity • One can establish relationship between I & O , hence performance measurement is relatively easy www.managementvikalp.co.in
- 13. 13 2. ExpensesCenter – 2.2) Discretionary Expenses Center -e.g. R&D, Advt. Dept, a Movie Project Discretionary expenses are those expenses which can not be established with perfect accuracy Inputs (Money spent on R & D) Output (Product Development) RC’s TASK • Difficult to estimate Input (hence called MANAGED costs) • Output can not be measured in monetary terms. • Difficult to establish optimal relationship between I and O • Performance Measure for the RC is Budgeted Input and Actual Input. www.managementvikalp.co.in
- 14. 14 Control Characteristicsof Discretionary Cost Center • Heavy Reliance on Budgets • For on going activity its bit easier than a new project • Budgeting technique used for controlling could be – • Incremental Budgeting • Zero Base Budgeting • Difficult to control short term fluctuations, as Discretionary costs usually remain unaffected in short term unlike engineered costs. www.managementvikalp.co.in
- 15. 15 Discretionary ExpensesCenter - Examples i) Administrative and Support Centers- Senior management units at corporate level e.g. Legal, Planning , IT , Audit Departments • Goals may differ and hence performance ii) Research and Development Centers – • The input and output may span over different and uneven time periods. iii) Marketing Center - www.managementvikalp.co.in
- 16. 16 3. ProfitCenter - Profit is most comprehensive measure of performance Function/Activity having highest influence on Bottom Line suits best for Profit Center. Can be a Business Division or any of the functional unit Demands highest freedom/autonomy than any other RCs’ Inputs (Money spent for earning profits) Output (Money-profit Earned out of sales) RC’s TASK Relationship can be established www.managementvikalp.co.in
- 17. Profit Center DecisionRights – 17 Input Mix – Labor, Material, Supplies Product Mix Selling Price Performance Measures – Actual Profits Actual Profit in comparison with budgeted profits Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix CANDIDATES FOR PROFIT CENTER …………… www.managementvikalp.co.in
- 18. 18 3. BusinessUnit as Profit Center Business Units In a Decentralized Company Best suited as Profit Center Marketing Center as Profit Center– Marketing Function having highest influence on Bottom Line, e.g. Colgate, Coca-Cola, Wipro- Bath Soaps division, Dabur-Cosmetics division etc. When centralized control is infeasible e.g. Foreign Marketing Center e.g. IBM, Microsoft, Honda India To Convert Marketing Division into Profit Center Charge cost of production to revenue center Grant of maximum autonomy to the unit Delegate sufficient authority Treat the unit as a mini company www.managementvikalp.co.in
- 19. 19 3. FunctionalUUnniitt aass PPrrooffiitt CCeenntteerr Manufacturing Division – When Cost of production having highest impact on Bottom Line and When Marketing Function is relatively insignificant o e.g. Nirama Detergent To convert a Production Division in to Profit Center Credit selling price less marketing expenses to production division 3. Service and Support Center – o e.g. Maintenance, Customer Service, Transportation, Engineering Design Divisions Given greater autonomy, helps them to cut cost and make its operations more efficient www.managementvikalp.co.in
- 20. 3. Profit Center– Performance Measures Performance Measure Justification 2. Direct Profit 20 Less Fixed Expenses All Expenses incurred at the behest of PC • Revenue Less VC of Mfg. & Marketing 1. Contribution Margin Fixed Cost is beyond control of PC Less Controllable Corporate Expenses 3. Controllable Profit Some HQ expenses exclusively incurred for given PC at HQ – IT services Less Other Corporate Allocations 4. Net Profit Before taxes Common unavoidable expenses incurred to run a company ; e.g. All administration, financing and tax planning activities are carried at HQ Less Income tax 5. Net Profit In some cases RC do have impact on tax liability of the company - Tax Heavens www.managementvikalp.co.in
- 21. 21 3. ProfitCenter - Advantages • Improves quality of decision – RC Mgr are closest to the point of decision • Improves speed of decision – less intervention by HQ • HQ is relieved of day-to-day decisions making process – can concentrate on more strategic decisions • Provides training ground for general mgt. as RC’s acts as mini Cos’. • Enhances profit consciousness with every expense made. (mktg. mgr. will tend to authorize promotional expenditure which increases the sales). • Provides best performance indicators of Co’s individual component. • Since output is clear cut evident, it evokes competition. • Ensures better and safer delegation of authority. • Ensures better motivation and evokes commitment. www.managementvikalp.co.in
- 22. 3. Profit Center– Dis-Advantages • Caliber of RC mgr. may hamper the decision. • Incase of more integrated company there may be problems of cost sharing, transfer pricing, sharing credit for revenue. • Divisionalisation may impose additional cost of admn/support units. • Functional set up may not have competent of GM to manage RC. • Functional units once cooperated may now be in competition with 22 one another- (as profit of one is loss to another). • May encourage short term motive at the expense of Co’s overall goal. • Optimization of RC’s profit not necessarily mean optimization of company’s profits. • Decentralization makes top mgt. to rely more on MC reports www.managementvikalp.co.in
- 23. 23 Responsibility Centers 4. Investment Centers – Inputs (Money spent for Starting & running the business) Output (Money/net profit Earned on account of investment) RC’s TASK • Objective – Make sound investment decision • It compares Business units profits with assets employed to earn that profit i.e. efficiency of assets employed. • It satisfies both the goals of business organizations i.e. to earn the profit and to achieve optimal relationship in profits earned and assets employed www.managementvikalp.co.in
- 24. 24 Investment Center Decision Rights – Input Mix – Labor, Material, Supplies Product Mix Selling Price Capital Investment Performance Measures – Actual ROI Actual Residual Income i.e. EVA Actual ROI & RI in comparison with budgeted ROI & RI Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix RC manager has knowledge about investment opportunities www.managementvikalp.co.in
- 25. 25 Return onInvestment – Return on Investment- Relating the profits of a firm with the investment made. ROI can be computed in many different ways depending upon the need and relevance. 1. Return on Assets - ROA 2. Return on Capital Employed - ROCE 3. Return on Shareholder’s Equity - ROE www.managementvikalp.co.in
- 26. 26 Return onInvestment – Return on Assets Net Profit 1) Return on Assets = --------------- * 100 Assets ROI terminology would change depending on what Assets base one takes for computation; it can be - Total Assets, Fixed Assets, Gross Assets, Net Assets, Tangible Assets or Employed Assets www.managementvikalp.co.in
- 27. 27 Return onInvestment – Return on Capital Employed Net Profit 2) Return on Capital Employed = ------------------------- * 100 Capital Employed Capital implies the long term funds supplied by creditors & owners Alternatively it can be Net Working Capital + Fixed Assets www.managementvikalp.co.in
- 28. 28 Return onInvestment – Return on Shareholders’ Equity Net Profit 3) Return on Shareholders’ Equity = ---------------- * 100 Equity Capital Equity includes the preferential capital, however the ordinary shareholder bears the entire risk. Net Worth represents the equity capital plus the reserves and surpluses the portion solely represented by equity holders’. Net Profit- Pref. Divi. Return on Shareholders’ Equity = ------------------- * 100 Net Worth www.managementvikalp.co.in
- 29. 29 Economic ValueAdded - EVA® (Stern & Stewart) As lender require certain interest on their money, owners too expect certain rate of return on their funds. (taken together both termed as cost of capital). Hence no "real" money is made or value is created until the operating profits exceed the rupee return required by the owner and the lenders. Increase in EVA, Increase in Market Value of the firm www.managementvikalp.co.in
- 30. 30 Economic ValueAdded – EVA® (Stern & Stewart) • EVA is another of the way to relate profits to assets employed. • Economic Value Added = Net Profit – Capital Charge Capital Charge = Capital Employed * Cost of Capital • EVA=Net profit – (Cost of Capital * Capital Employed) • This is nothing but Residual Income which adds to the value of the firm www.managementvikalp.co.in
- 31. 31 Return onInvestment V/s Economic Value Added 1. EVA is Profitability measure in money term. Can not be used for comparison with other Business Unit or Industries. 1. ROI is a ratio. Simple & easy to understand, Meaningful in absolute sense. Being a common denominator of industries it can used for comparison. www.managementvikalp.co.in
- 32. 32 Return onInvestment V/s Economic Value Added 2. EVA provides an effective measure than ROI. EVA Stresses upon recovery of cost of capital. And welcomes every rupee earned over and above COC. 2. Different ROI % provides different incentives across BUs’ (e.g. BU having current ROI of 30 will be discouraged to go for additional investment giving 25% ROI, even though the ROI is greater than Cost of Capital OR BU mgr can improve its ROI by just disposing the assets which give lesser ROI than current one) www.managementvikalp.co.in
- 33. 33 Return onInvestment V/s Economic Value Added 3. EVA enables to use different rates of interest for different types of assets involving different risks. e.g. low rate for inventory investment whereas higher rate for fixed investment. 3. ROI does not allow different treatment for different kind of assets i.e. it treats all assets/investments at par. www.managementvikalp.co.in
- 34. 34 Return onInvestment V/s Economic Value Added EVA has got strong & positive correlation with market value of the firm. 4. It is difficult to define an explicit relationship between ROI and Market value of the firm. (ROI not necessarily indicate the market value of the firm.) (shareholders worth maximization may not be suitable measure for RC’s performance evaluation Because it is consolidated effect of entire company) www.managementvikalp.co.in
- 35. Return On Investment www.managementvikalp.co.in 35
- 36. Momence Associates isevaluating the performance of three divisions: Maple, Oaks, and Juniper. Using the following data, compute the return on investment and residual income for each division, compare the divisions’ performance, and comment on the factors that influenced performance. Maple Oaks Juniper Sales $100,000 $100,000 $100,000 Operating income $ 10,000 $ 10,000 $ 20,000 Assets invested $ 25,000 $ 12,500 $ 25,000 Desired ROI 40% 40% 40% 36 www.managementvikalp.co.in
- 37. Solution Momence Associatesis evaluating the performance of three divisions: Maple, Oaks, and Juniper. Using the following data, compute the return on investment and residual income for each division, compare the divisions’ performance, and comment on the factors that influenced performance. Maple Oaks Juniper Sales $100,000 $100,000 $100,000 Operating income $ 10,000 $ 10,000 $ 20,000 Assets invested $ 25,000 $ 12,500 $ 25,000 Desired ROI 40% 40% 40% ROI=Operating Income/Assets Invested Maple= $10,000/$25,000= 40% Oaks= $10,000/$12,500= 80% Residual Income=Operating Income-(Desired ROI x Assets Invested) Maple= $10,000-(40% x $25,000)= $0 Oaks= $10,000-(40% 37 www.managementvikalp.co.in x $12,500)= $5,000
- 38. Economic Value Added www.managementvikalp.co.in 38
- 39. E 13. Leesburg,LLP, is evaluating the performance of three divisions: Lake, Sumter, and Poe. Using the following data, compute the economic value added by each division and comment on each division’s performance. Lake Sumter Poe Sales $100,000 $100,000 $100,000 After-tax operating income $ 10,000 $ 10,000 $ 20,000 Total assets $ 25,000 $ 12,500 $ 25,000 Current liabilities $ 5,000 $ 5,000 $ 5,000 Cost of capital 15% 15% 15% 39 www.managementvikalp.co.in
- 40. E 13. SolutionLeesburg, LLP, is evaluating the performance of three divisions: Lake, Sumter, and Poe. Using the following data, compute the economic value added by each division and comment on each division’s performance. Lake Sumter Poe Sales $100,000 $100,000 $100,000 After-tax operating income $ 10,000 $ 10,000 $ 20,000 Total assets $ 25,000 $ 12,500 $ 25,000 Current liabilities $ 5,000 $ 5,000 $ 5,000 Cost of capital 15% 15% 15% EVA= After-tax operating income - Cost of capital(TA-CL) Lake: $10,000 – 15%($25,000-$5,000) = $7,000 Sumter: $10,000 – 15%($12,500-$5,000) = $8,875 40 www.managementvikalp.co.in
- 41. Computing EVA forHLL Calculation of www.managementvikalp.co.in 41 ROCE 1999 1998 1997 1996 Operation Profit 1,206 956 711 464 - Less Depreciation 129 101 58 55 - Less Tax Paid 318 286 281 173 - Less Tax shield on interest 5 8 11 17 Net Optg Profit less adj Taxes (NOPLAT) 754 562 361 219 Average Capital Employed 2,118 1,703 1,412 688 WACC (%) 19 18 19 22 Capital Charge 402.42 306.54 268.28 151 EVA 351.58 255.46 92.72 98
- 42. Incremental Analysis inthe Responsibility Center Incremental analysis is used to find the impact of changes in costs or revenues, given a specific potential scenario. Decisions involving incremental analysis include the following: Make or buy (Profit Center) Sell or process further (Revenue Center) Special order (Cost Center) Changes in production and/or technology (Investment Center) 42 www.managementvikalp.co.in
- 43. . Identify eachof the following as a cost center, a discretionary cost center, a revenue center, a profit center, or an investment center. 1. The manager of center A is responsible for generating cash inflows and incurring costs with the goal of making money for the company. The manager has no responsibility for assets. 2. Center B produces a product that is not sold to an external party. 3. The manager of center C is responsible for the telephone order operations of a large retailer. 4. Center D designs, produces, and sells products to external parties. The manager makes both long-term and short-term decisions. 5. Center E provides human resource support for the other centers in the company. 43 www.managementvikalp.co.in
- 44. Solution 1. Themanager of center A is responsible for generating cash inflows and incurring costs with the goal of making money for the company. The manager has no responsibility for assets. P 2. Center B produces a product that is not sold to an external party. C 3. The manager of center C is responsible for the telephone order operations of a large retailer. R 4. Center D designs, produces, and sells products to external parties. The manager makes both long-term and short-term decisions. I 5. Center E provides human resource support for the other centers 44 www .imnan atghemee nctviokamlp.cpo.ianny. DC`
- 45. Identify the mostappropriate type of responsibility center for each of the following organizational units. 1. A pizza store in a pizza chain 2. The ticket sales center of a major airline 3. The South American segment of a multinational company 4. A subsidiary of a business conglomerate 5. The information technology area of a company 6. A manufacturing department of a large corporation 7. An eye clinic in a community hospital 8. The food-service function at a nursing home 9. The food-preparation plant of a large restaurant chain 10. The catalog order department of a retailer 45 www.managementvikalp.co.in
- 46. Solution 1. Apizza store in a pizza chain P 2. The ticket sales center of a major airline R 3. The South American segment of a multinational company I 4. A subsidiary of a business conglomerate I 5. The information technology area of a company DC 6. A manufacturing department of a large corporation C 7. An eye clinic in a community hospital P 8. The food-service function at a nursing home C 9. The food-preparation plant of a large restaurant chain C 10. The catalog order department of a retailer R 46 www.managementvikalp.co.in
- 47. A simple summaryof the responsibility centers Revenue Center Output measured in monetary terms Input measured in monetary terms Output measured in monetary terms Output measured in monetary terms Expense/Cost Centers Profit Centers Investment Centers 47 www.managementvikalp.co.in
- 48.
Editor's Notes
- #4 Underlying the accounting classifications of responsibility centers is the concept of controllability. The controllability principle asserts that people should only be held accountable for results that they can control.
- #5 It is often difficult to apply the controllability principle at the lowest organizational level.
- #6 A well designed system should clearly define responsibility centers in order to collect and report revenue and cost information by areas of responsibility.
- #8 Typical examples of these organizational entities are Sales organizations.
- #43 The use of Incremental Analysis in the Responsibility Center affects both fixed and variable costs.