Responsibility centers final Prof Rishi Chourasia

Prof Rishi ChourasiaManagement Vikalp

Responsibility Centers

1 www.managementvikalp.co.in

What is a Responsibility 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 applying it scrupulously2 www.managementvikalp.co.in

Responsibility Centers further defined

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.


The basic definition of a responsibility center

Lowest organizational level at which funds control functions are carried out. Generally the same as divisions in an operating component.


For accounting purposes, responsibility centers have four classifications:

Revenue Centers

Cost Centers

Profit Centers

Investment Centers


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Responsibility Centers -

Prime concern of the REVENUE CENTER – “TOPLINE”

1. Revenue Center -

Inputs (Money directly spent on achieving sales i.e. Mktg. Exp.)

Output (Sales Generated in money terms)

RC’sTASK

• 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.

Generate Sales

e.g. Marketing center

www.managementvikalp.co.in

Revenue CenterA Revenue 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.


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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


2. Expense/Cost CentersResponsibility centers whose employees control

costs, butDo not control their revenues or investment level.Examples: Production department in a

manufacturing unit, a dry cleaning businessTwo 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).

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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


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Cost Center

Decision Rights – Input Mix – Labor, Material, Supplies

Performance Measures – Minimize total cost for a fixed output Maximize output for a given “cost budget”

Typically used when – RC manager can measure output & quality of output knows cost functions, optimal input mix can set optimal quantity and appropriate rewards

Inputs (Money spent on production)

Output (Physical units Produced)

RC’sTASK


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2. Expenses Center –

Engineered expenses are those expenses which are arrived at with reasonable reliability.e.g. Material cost , labor cost.

• 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

2.1)Engineered Exp. Center e.g. Production Department

Inputs (Money spent on production)

Output (Physical units Produced)

RC’sTASK


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2. Expenses Center –

Discretionary expenses are those expenses which can not be established with perfect accuracy

2.2) Discretionary Expenses Center -e.g. R&D, Advt. Dept, a Movie Project

Inputs (Money spent onR & D)

Output (Product Development)

RC’sTASK

• Difficult to estimate Input (hence called MANAGED costs)• Output can not be measured in monetary terms.

• Performance Measure for the RC is Budgeted Input and Actual Input.

• Difficult to establish optimal relationship between I and O


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Control Characteristics of 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.


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Discretionary Expenses Center - 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 -


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3. Profit Center - Profit is most comprehensive measure of performanceFunction/Activity having highest influence on Bottom

Line suits best for Profit Center.Can be a Business Division or any of the functional unitDemands highest freedom/autonomy than any other

RCs’

Inputs (Money spent for earning profits)

Output (Money-profit Earned out of sales)

RC’sTASK

Relationship can be established


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Profit CenterDecision Rights –

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 mixCANDIDATES FOR PROFIT CENTER ……………


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3. Business Unit as Profit CenterBusiness Units In a Decentralized Company

Best suited as Profit CenterMarketing 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 CenterCharge cost of production to revenue center Grant of maximum autonomy to the unitDelegate sufficient authorityTreat the unit as a mini company


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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

3. Functional Unit as Profit Center3. Functional Unit as Profit Center


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2. Direct Profit Less Fixed Expenses

All Expenses incurred at the behest of PC

• RevenueLess 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 expensesincurred to run a company ; e.g.All administration, financing and tax planning activities are carried at HQ

Less Income tax

5. Net ProfitIn some cases RC do have impact on tax liability of the company - Tax Heavens

3. Profit Center – Performance Measures

Performance Measure Justification


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3. Profit Center - 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.


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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 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


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Responsibility Centers

4. Investment Centers –

Inputs (Money spent for Starting & running the business)

Output (Money/net profit Earned on account of investment)

RC’sTASK

• 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


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Investment CenterDecision Rights –

Input Mix – Labor, Material, SuppliesProduct MixSelling PriceCapital Investment

Performance Measures – Actual ROI Actual Residual Income i.e. EVAActual 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


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Return on Investment –Return on Investment-

Relating the profits of a firm with the investment made.

1. Return on Assets - ROA

2. Return on Capital Employed - ROCE

3. Return on Shareholder’s Equity - ROE

ROI can be computed in many different ways depending upon the need and relevance.


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Return on Investment – Return on Assets

Net Profit

1) Return on Assets = --------------- * 100

AssetsROI 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 Assetswww.managementvikalp.co.in

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Return on Investment – 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


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Return on Investment – 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


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Economic Value Added - 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


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Economic Value Added – 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


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Return on Investment 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.


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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

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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.


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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)



Return On Investment

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Momence Associates is 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 $100,000Operating income $ 10,000 $ 10,000 $ 20,000Assets invested $ 25,000 $ 12,500 $ 25,000Desired ROI 40% 40% 40%


Solution Momence Associates is 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 JuniperSales $100,000 $100,000 $100,000Operating income $ 10,000 $ 10,000 $ 20,000Assets invested $ 25,000 $ 12,500 $ 25,000Desired ROI 40% 40% 40%

ROI=Operating Income/Assets InvestedMaple= $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)= $0Oaks= $10,000-(40% x $12,500)= $5,00037 www.managementvikalp.co.in


Economic Value Added

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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 PoeSales $100,000 $100,000 $100,000After-tax operating income $ 10,000 $ 10,000 $ 20,000Total assets $ 25,000 $ 12,500 $ 25,000Current liabilities $ 5,000 $ 5,000 $ 5,000Cost of capital 15% 15% 15%


E 13. Solution 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 PoeSales $100,000 $100,000 $100,000After-tax operating income $ 10,000 $ 10,000 $ 20,000Total assets $ 25,000 $ 12,500 $ 25,000Current liabilities $ 5,000 $ 5,000 $ 5,000Cost of capital 15% 15% 15%

EVA= After-tax operating income - Cost of capital(TA-CL)

Lake: $10,000 – 15%($25,000-$5,000) = $7,000Sumter: $10,000 – 15%($12,500-$5,000) = $8,875


www.managementvikalp.co.in 41

Computing EVA for HLLCalculation of

ROCE1999 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

Incremental Analysis in the 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)


. Identify each of 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.


Solution1. 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. 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 in the company. DC`


Identify the most appropriate type of responsibility center for each of the following organizational units.

1. A pizza store in a pizza chain2. The ticket sales center of a major airline3. The South American segment of a multinational

company4. A subsidiary of a business conglomerate5. The information technology area of a company6. A manufacturing department of a large

corporation7. An eye clinic in a community hospital8. The food-service function at a nursing home9. The food-preparation plant of a large restaurant

chain10. The catalog order department of a retailer


Solution1. A pizza store in a pizza chain P2. The ticket sales center of a major airline R3. The South American segment of a multinational

company I4. A subsidiary of a business conglomerate I5. The information technology area of a company DC6. A manufacturing department of a large corporation C7. An eye clinic in a community hospital P8. The food-service function at a nursing home C9. The food-preparation plant of a large restaurant chain

C10. The catalog order department of a retailer R


A simple summary of the responsibility centers

Revenue CenterOutput 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


Responsibility centers final Prof Rishi Chourasia

Economy & Finance

cost unit

discretionary expenses

labor cost

cost center direct labor

total cost

material cost

cost of marketing

cost functions