Management Control Systems

2 - Responsibility Centers

July 2009

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2 - Responsibility Centers
A responsibility center is one of the several types of the organizational segment,
focused in the manager’s behavior, being a relevant management tool to organize the
alignment of the decision towards the corporation strategy. In simple words: an
organizational unit for which a manager is made responsible.

The mainly interest of the responsibility centers is:

1. They are like “small business”, and its manager are asked to run that small
business and preserve the interests of the larger organization;

2. Goals for the center should be specific and measurable;

3. Should promote the long terms interests of the organization and should be
compatible with other responsibility center activities;

4. Create an entrepreneurship view for its managers.

The advantages of responsibility centers are as follows:

1. they facilitate the control of some financial factors by specialists in budgets who
do not need to know technological details;
2. they allow identification of the contribution from each responsibility centre
towards the entity’s profit.

The responsibility centre has the following characteristics:

 has a well-defined type of activity through its statute or its founding contract,
having competences in keeping, developing, replacing and reducing the assets;
 can administer an asset;
 has an organizational, functional and productive structure, with competence in
defining it;
 plans and changes its own set of rules for organization and functioni ng;
 has its own tasks in production;
 devises its own expense budget;
 evaluates and administers its own budget resources;
 emphasizes its own financial results;
 devises monthly accounting balances or, if necessary, the final balance;
 emphasizes its own savings and/ or profit;
 takes responsibility for the results obtained;
 is not responsible for the unprofitable activities of other centers within the entity;
 cooperates with other centers to accomplish activities by signing collaborative
conventions;

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  uses its resources to get performance;
 may attract partners but it does not have competence in signing economic
agreements;
 has a manager (only one) who is responsible for the performances of the
responsibility centre.

One of the most important questions in finance is the knowledge of the segment
profitability, relevant information to help managers to act, to take better decisions and to
evaluate the performance.

2.1. Segment Reporting and Profitability

Decentralization and segment reporting

A segment is a part or activity of an organization about which managers need to

know cost, revenue or income data. Examples of segments include divisions of a
company (responsibility centers), sales territories, projects, product families, individual
stores, programs, operational departments, individual customers, services categories and
product lines.

Effective decentralization requires segment reporting, so the companywide

income statement, reports are needed for individual segments of the organizations.
These segmented income statements are useful in analyzing the profitability of
segments and measuring the performance of segment managers.

A different kind of income statement is required for evaluating the performance

of a cost center, a profit center or an investment center. This income statement should
emphasize on the segment rather than the performance of the company as a whole. A
contribution margin or a residual contribution margin, format income statement is used
to evaluate the performance of different types of segments.

In a contribution margin format income statement cost of the segment consists

only of the direct costs (variable and fixed costs). To prepare an income statement for a
particular segment variable costs are traced for the resources which use depends of the
degree of the activity of the segment and the fixed costs don´t depends of the degree of
the activity, but are related with the segment. This fixed cost are designated by traceable
fixed and are assigned to the segments but non-traceable or common fixed costs are not
assigned to segments.

Segment Contribution Margin

The segment contribution margin is obtained by deducting the variable and the
traceable fixed costs from the segment revenues. It represents the margin that is

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available after a segment has covered all of its own costs. The segment contribution
margin can be 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 is own costs,
then that segment probably should not be retained (unless it has an important side
effects on other segments or is strategic relevant).

From a decision making point of view, the segment contribution margin is most
useful in major decisions that affect capacity such as dropping a segment, including
decisions relating to short-run changes in volume, such as pricing special orders that
involve utilization of existing capacity.

Example

As an example, a segmented report is shown, where the segments have been defined as
divisions. Report also has a column of total company performance for the period. We can see
that divisional segment margin is €60,000 for business product division and €40,000 for the
consumer product division. This report is very useful for company's divisional managers they
may want to know how much each of their divisions is contributing to the company's profit.

Segments defined as divisions (values in m€):

Total
__Segments______
company
Division A Division B
Revenues (ex: sales) 100,000 60,000 40,000
------------- ------------- ------------
Variable expenses:
Cost of goods sold 36,000 24,000 12,000
Other variable expenses 10,000 6,000 4,000
------------ ------------ ------------
Total variable expenses 46,000 30,000 16,000
------------ ------------ ------------
Margin 54,000 30,000 24,000
Traceable fixed expenses 34,000 18,000 16,000
------------ ------------ ------------
Divisional Contribution margin 20,000 12,000 8,000
Common fixed expenses (not ===============
traceable to the individual divisions) 17,000
------------
Net operating income 3,000

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 Traceable and Common Fixed Costs

One of the most puzzling aspects of segmented income statements is probably

the treatment of fixed costs. While preparing segmented income statements the fixed
cost is divided into two parts, one is traceable fixed cost and other is common fixed
cost. Only traceable fixed costs are assigned to the segment. If a cost is not traceable
then it is not assigned to segments. Following paragraphs define explain these two types
of fixed costs.

Traceable fixed cost:

A traceable fixed cost is a fixed cost that is incurred because of the existence of
a segment. If the segment had never existed, the fixed cost would have not been
incurred; and if the segment were eliminated, the fixed cost would disappear.

Examples:
Examples of traceable fixed costs:

 The salary of the Division A manager is a traceable fixed cost of the Division A.
 The renting of the equipment to produce exclusively the “Product Line P”, is a traceable
fixed cost of the Product Line P.
 The depreciation of a car for rent is a traceable fixed cost of the “renting business” in a
rent a car company.

Common fixed cost:

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 part to any one segment. Even if a
segment were entirely eliminated, there would be no change in true common fixed cost.

Examples:
Example of common fixed cost includes the following:

 The salary of general manager who controls all the segments. The salary of CEO at
TELECOM is also an example of common fixed cost. No single segment can be
regarded as the sole reason of this cost.
 The salary of receptionist at an office shared by a number of doctors is a common fixed
cost of the doctors. The cost is traceable to the office, but not to any one of the doctors
individually.

Identifying traceable and common fixed costs is crucial in segment reporting,

since the traceable fixed costs are charged to the segments and common fixed costs are
not charged to segments. In actual situations, it is sometimes hard to determine whether
a cost should be classified as traceable or common. The general guideline is to treat as
traceable costs only those costs that would disappear over time if the segment itself
disappeared.

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 Traceable cost is also common cost

Fixed cost that is traceable to one segment is, usually, a common cost for
another segment. For example, one Trading Company might want a segmented income
statement that shows the segment margin for each territory where is operating and for
each client. The fixed territory manager salary is a traceable fixed cost of one territory,
but it is a common fixed cost of the client segment of that territory. So, traceable and
common cost is relative concepts.

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.

Inappropriate methods for allocating costs among segments:

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.

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 companywide overhead pool
and then spread throughout the company.

Some companies allocate costs to segments using arbitrary bases such as sales
value or cost of goods sold. For example, under the sales value approach, costs are
allocated to the various segments according to the percentage of company sales
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generated by each segment. If a segment generates 20% of total company sales, it would
be allocated 20% of the company's overheads 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 value is used as the allocation
based for SG&A expense, it is implicitly assumed that overheads expenses change in
proportion to change in value sales. If that is not true, the allocated expenses 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 no traceable costs to segments. For example, some companies allocate the
costs of the corporate headquarters building to products on segment reports. However,
in a multiproduct 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. 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.

2.2. Residual Income

Residual income is the net operating income that an investment center earns
above the minimum required return on its operating assets. Residual income is a
consistent approach to measuring an investment center's performance. Economic Value
Added (EVA) is an adoption of residual income that has recently been adopted by many
companies. When residual income or EVA is used to measure managerial performance,
the objective is to maximize the total amount of residual income or EVA.

Example

For the purpose of illustrating, consider the following data for an investment center of a
company.

Basic Data for Performance Evaluation

Average operating assets € 80,000
Net operating income €18,000
Minimum required rate of return 15%

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 The company has long had a policy of evaluating investment center managers based on
ROI, but it is considering a switch to residual income. The following table shows how the
performance of the division would be evaluated under each of the two methods:

Alternative Performance
Measures
ROI Residual
income
1. Average operating assets € 80,000 € 80,000
======= =======
2. Net operating income € 18,000 € 18,000
ROI, (2) ÷ (1) 22,5%
Minimum required return (15% € 12,000
€80,000) ----------
€ 6,000
Residual income =======

Comparison of return on investment (ROI) and residual income:

One of the primary reasons why controllers of companies would like to switch
from ROI to residual income has to do with how managers view new investment under
the two performance measurement schemes. The residual income approach encourages
managers to make investments that are profitable for the entire company but that would
be rejected by managers who are evaluated by ROI formula.

To illustrate consider the data mentioned above and further suppose that the
manager of the division is considering purchasing a machine. The machine would cost €
25,000 and is expected to generate additional operating income of € 4,500 a year. From
the stand point of the company, this would be a good investment since it promises a rate
of return of 18% [(€4,500 / €25,000) ×100], which is in excess of the company's
minimum required rate of return of 15%. If the manager of the division is evaluated
based on residual income, he would be in favor of the investment in the machine as
shown below.

Performance evaluated using residual income

Present New Project Overall
Average operating assets € 80,000 € 25,000 € 105,000
======= ======= ========
Net operating income € 18,000 € 4,500 € 22,500
Minimum required return € 12,000 € 3,750 € 15,750
----------- ----------- -----------
Residual income € 6,000 € 750 € 6,750
======== ======== =======

Since the project would increase the residual income of the division, the
manager would want to invest in the new machine.

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 Now suppose that the manager of the division is evaluated based on the return
on investment (ROI) method. The effect of the machine on the division's ROI is
computed as below:

Performance evaluated using residual income

Present New project Overall
Average operating assets (1) € 80,000 € 25,000 €105,000
Net operating income (2) € 18,000 € 4,500 € 22,500
ROI, (2) ÷ (1) 22,5% 18% 21,4%

The new project reduces the ROI from 22, 5% to 21,4%. This happens because
the 18% rate of return on the new machine, while above the company's15% minimum
rate of return, is below the division's present ROI of 22,5%. Therefore the new machine
would drag the division's ROI down even though it would be a good investment from
the standpoint of the company as a whole.

Basically, a manager who is evaluated based on ROI will reject any project
whose rate of return is below the division's current ROI even if the rate of return on the
project is above the minimum rate of return for the entire company. In contrast, any
project whose rate of return is above the minimum required rate of return of the
company will result in an increase in residual income. Since it is in the best interest of
the company as a whole to accept any project whose rate of return is above the
minimum rate of return, managers who are evaluated on residual income will tend to
make better decisions concerning investment projects than manager who are evaluated
based on ROI. So, in financial point of view, residual income leads managers to take
decisions more aligned with overall company interest. Residual income is more
convergent than ROI.

2.3. Types of Responsibility Centers

The responsibility center is the key budget-management and decision-making

unit. There are three types of responsibility centers:

1. Profit centers which generate operating revenue and incur costs and so, they
provide revenue to support the cost centers. The profit center is the operational
subdivision which performs its activity by attracting resources which generate
revenue. The profit center is the organizational center within which profit can be
calculated. Within profit centers there are produced subsystems, finite products
or there are executed services which are sold outside and for which a selling
price is calculated.

2. Cost centers are administrative units that provide support services to the
company. In financial terms, they generate only operational costs. The cost
centre may be an enterprise, a department, a section, a functional service which
collects indirect expenses.

3. Investment Centers which generates not only revenues and operating costs, but
also operating assets (investment). Represents a profit center whit more
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 decentralization. The investment center is the organizational link in which there
can be emphasized the relationship/ difference between the revenue obtained
from product sales and the investment made for all the necessary resources.

Evaluating Responsibility Centers

To evaluate Responsibility Centers performance, we must observe the

Controllability Principle, that is, the manager of a responsibility center should be held
responsible only for the revenues, costs, or investment that responsibility center
personnel control. Must be excluded: revenues, costs, or investments that people outside
the responsibility center’s control
Performance measures must be used more to influence, less to evaluate, that is,
when more costs or revenues are included in performance measures, managers are more
motivated to find actions that can influence incurred costs or generated revenues.
Each responsibility center is accountable for meeting specified programmatic
and financial performance targets. Programmatic goals and financial performance
targets are set by senior management, in collaboration with the Unit’s leadership and the
controller, as part of the annual budget process.
The evaluation measures of each responsibility center, are:

Cost Centers
Control: A cost center is a business segment whose manager has control
over costs but not over revenue or investment funds.
Candidate: processing group
Evaluation: actual costs vs. target/standard costs

Profit Centers
Control: A profit center is any business segment whose manager has
control over both cost and revenue
Candidate: individual units of chain operation
Evaluation: contribution margin relative to target

Investment Centers
Control: An investment center is any segment of an organization whose
manager has control over cost, revenue and investments in
operating assets.
Candidate: independent business
Evaluation: Residual Income (before tax) relative to target

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 Transfer Prices

Transfer pricing is the set of rules an organization uses to allocate jointly earned
revenue among responsibility centers. The primary purpose of producing management
accounting numbers is to motivate desirable behavior regarding managers’ decision
making. Transfer prices change the traditional organization in cost centers, to a more
decentralized and entrepreneurship organization in profit centers and investment
centers. Sale of a new car with a trade-in will affect profits of both the dealership’s new
car dept. and used care dept.
The types of transfer prices that are usually applied in pricing transactions
between responsibility centers are the following:

 Market-based transfer prices (transfer price is based in the adjusted market price
of the good or service transferred between responsibility centers);
 Cost-based transfer prices (transfer price is based in the cost of the product or
service transferred between responsibility centers);
 Negotiated transfer prices (transfer price is based in the value negotiated
between managers of the responsibility centers)
 Administered transfer prices (transfer price is fixed by the company)

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