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• Nature of Responsibility centers • Measurement of inputs and outputs
Types of Responsibility Centers
• Revenue centers • Expense centers • Engineered expense centers • Discretionary expense centers
Control characteristics for expense centers
• Budget preparation
• • •
Cost variability: Financial control: Measurement of performance:
Administrative and support centers
Research and development centers
• Marketing centers • Profit centers
Types of profit centers
• Manufacturing • Measuring profitability
Types of profitability measures
• Contribution margin • Direct profit
• Income before taxes
• Investment centers • Cost centers
Responsibility center is a unit or function of an organization headed by a manager who is directly responsible for its performance. In a responsibility center, the accounting system generates information on the basis of managerial responsibility, allowing that information to be used directly in motivating and controlling the action of each manager in charge of a responsibility center. Responsibility centers can be assigned very narrowly or broadly in terms of the activities that senior management decides to assign to a particular manager. But the type of responsibility center specifically defines the primary objective of the decisions required when managing the assigned activity. For example, as a cost center, a manager would focus on reducing costs in relation to a standard cost or budget, and would not be concerned about the profit margins of the various products or the implications of these decisions on the company's profitability. However, in designating this center as a cost center, the senior management should have already decided that the profit implications would be controlled by another part of the entire system.
Nature of Responsibility Centers
Every organization has its goals determined, and the management decides upon the strategies to accomplish these goals. Responsibility centers help in implementing these strategies. As an organization is a collegiums of responsibility centers, the ability of its responsibility centers to meet their objectives help an organization to achieve its goals. Every responsibility center uses inputs (material, labor, etc.) and needs working capital, equipment and other assets to function effectively. The responsibility center produces outputs which are classified as goods and services and hence they can be measured, whereas in human resources, transportation, accounting and administration, the output is services that cannot be measured.
Measurement of inputs and outputs
It is easy to identify the monetary costs of physical quantities. The amount of money is calculated by multiplying the physical quantity by a price unit of quantity. Therefore, the inputs of a responsibility center are referred to as costs. While the costs of inputs can be easily measured, outputs are not so easy to measure. The performance of a responsibility center can be judged by using the effectiveness and efficiency criteria. Efficiency is the ratio of outputs and inputs. These measures are usually used on a comparative basis. If there are two responsibility centers, A and B, responsibility center A would be considered more efficient than responsibility center B if it uses less resources than B but has the same output, or if it uses the same amount of resources, but produces more output. If both the centers are found to be performing up to the company’s expectations, the center that shows the lower costs is considered more efficient. The effectiveness of the unit is decided on the basis of a unit’s outputs and its objectives. The greater the contribution of the outputs to the accomplishment of the organizational objectives, the more effective is the unit. A unit should be both effective and efficient to contribute to the achievement of these goals. The company’s overall profit can be considered as the base for measuring effectiveness and efficiency.
TYPES OF RESPONSIBILITY CENTERS
According to the nature of monetary inputs and outputs, responsibility centers can be classified into the following:
Revenue centers are those organizational units in which outputs are measured in monetary terms. These centers are marketing organizations and they are not directly responsible for profits. Revenue centers are also called expense centers, as the revenue center managers are held responsible for expenses incurred by the unit. The main objective of revenue centers is to maximize revenues. For example, a marketing organization is a sales revenue center. Such a center is devoted to increasing the revenue, and assumes no responsibility for production. In this center, the manager is responsible for the level of revenue or outputs of a center, measured in monetary terms, but is not responsible for the costs of the goods or services that the center offers.
In expense centers, inputs or expenses are measured in monetary terms whereas the outputs are not measured in monetary terms. There are two types of expense centers-engineered expense centers and discretionary expense centers. There are two types of cost involved in engineered expense centers and discretionary expense centers respectively-engineered costs and discretionary costs. Engineered costs are costs that can be estimated to a reasonable extent by the management. Examples are direct labor and direct material. Discretionary costs, on the other hand, are costs that cannot be estimated by the management.
Engineered expense centers
In these centers, inputs or expenses are measured in monetary terms and outputs are measured in physical terms. These centers are usually found in the manufacturing units that use a standard cost system. There are certain responsibility centers within administrative and support departments that actually are engineered expense centers. In these centers, the cost of the product is determined by multiplying the output of each unit with its standard cost. Its efficiency is measured by comparing the actual cost with the standard cost.
Discretionary expense centers
In discretionary expense centers, the output cannot be measured in monetary terms. Discretionary expense centers include administrative and support units like legal, accounting, industrial and public relations units. Here, the efficiency is not the difference between budgeted and actual expense, but the difference between the budgeted input and actual input. In discretionary expense centers the management decides on certain policies that should govern the company's operation. These relate to the amount of money that should be spent on R&D, financial planning, public relations, etc. The decisions related to such activities depend on the way a company operates.
CONTROL CHARACTERISTICS FOR EXPENSE CENTERS
The management control systems for expense centers are discussed, taking into consideration factors like budget preparation, cost variability, financial control and measurement of performance.
Budget preparation: The decisions regarding the budget of expenses for a
discretionary expense center is different from that for an engineered expense center. In engineered expense centers, the costs are determined by the management, taking into view the operating budget required to perform the task effectively in the future. However, in a discretionary expense center, the principal task is to decide on the magnitude of the job that has to be performed. These tasks
are of two types-continuing and special. Continuing tasks take place year after year (like financial statements) while special tasks are one-time tasks, for example, developing a profit budgeting system for a newly acquired division. Management by objectives is a useful technique in preparing budgets for a discretionary expense center. Management by objectives is a technique where the objectives of performance are jointly determined by subordinates and their superiors. The progress towards these objectives is periodically reviewed and the rewards are allocated on the basis of performance. Another method used to understand the appropriate level of spending in a discretionary expense center is sensitivity analysis. According to this technique, the budget has a section which explains the activities that can be undertaken if the budget is increased. Sensitivity analysis is mostly not taken by companies as they think that it is important for a manager to prepare the possible budget for accomplishing activities that should be undertaken.
Cost variability: The costs, in a discretionary expense center, tend to vary from
one year to another according to the volume. However, these are not influenced by short-term fluctuations in volume within a year. In engineered expense centers, costs vary with short-term fluctuations in volumes.
Financial control: The financial control in a discretionary expense center is
different from that in an engineered expense center. Here, the operating costs are minimized by setting a standard for the costs and comparing the actual costs with this standard. In discretionary expense centers, costs are controlled by determining the tasks that have to be undertaken and the amount of effort that is required for each task. Financial control is, hence, determined at the planning stage.
Measurement of performance: The financial performance report of a
discretionary expense center does not help in evaluating the efficiency of the manager, whereas in engineered expense centers the financial report helps in
evaluating the efficiency of the manager. If the two centers are not properly distinguished, the management may consider the performance report of a discretionary center as an indication of its efficiency.
Administrative and support centers
Administrative centers include the senior corporate management, the business unit management and the managers responsible for their staff units. Support centers provide services to other responsibility centers. Problems related to control in administrative and support centers include difficulty in measuring output, as they basically provide service and advice to the responsibility centers. Therefore, it becomes difficult to set cost standards. Hence, their performance cannot be branded as efficient or inefficient. Secondly there is lack of congruence between goals of staff units and responsibility centers. The suggestions that staff departments may provide regarding the development of systems, programs or functions may be too costly when one thinks of the additional profits that these would generate. The severity of the problems is also related to the organizational level. At the operational level, the staff activity is controlled by the plant manager, and at the business unit level, by the business unit manager. When compared to the plant level, there is more discretion of tasks at the business unit level. Support centers charge a particular price for the services they provide to other responsibility centers.
Budget preparation: The budget for a support center consists of expenses, and
is prepared by comparing with the current year’s actual. This budget consists of the following components- the basic costs of running a center (for which there is no need of management decisions), costs incurred by the discretionary activities of the
center, and a section containing proposed increases in budget (other than those related to inflation).
RESEARCH AND DEVELOPMENT CENTERS
Control problems in research and development: The problems in research and development are: Difficulty in measuring quality: The inputs for an R&D activity can be measured whereas the outputs are difficult to measure. For R&D activities, the time taken for a particular research cannot be estimated as it may take months or sometimes years for a particular activity. Also the output is difficult to measure because of its technical nature. Lack of goal congruence: As in administrative centers, goal congruency is lacking in R&D centers, too. Conflict may arise between the research manager and the business unit manager. The research manager may want to build the best research and development center, no matter what the expense be, while it may not be possible for the company to afford it. Also, the researchers may not have sufficient knowledge about the business, in some cases. The research and development costs cannot be controlled on a year-to-year basis because a research project may take years to show results and the organization would have to bear the cost of the project for that period of time, mainly the cost on labor.
There are two types of marketing activities in every organization: order filling (logistics) and order getting. Order getting is an actual marketing activity. Order
filling activities include transferring goods from the company to the customer, and receiving the appropriate pay from the customer. These are mostly engineered expense centers. Order getting activities include test marketing, training sales force, advertising, sales promotion, etc. Though the output of a marketing organization can be measured, it is difficult to evaluate the marketing effort, as the marketing department has no control over economic conditions or competitors’ actions. These actions may be different from what was expected when the sales budgets were established. In such situations, it is difficult to achieve management control. Also, it becomes difficult to measure the efficiency and effectiveness of these costs.
When financial performance of a responsibility center is measured in terms of the organization’s profit, then it is called a profit center. In a profit center, performance is measured in terms of the numerical difference between revenues (outputs) and expenditure (inputs). A profit center is given the responsibility of earning profits. It is involved in the manufacture and sale of outputs, and it measures how well the center is doing economically. The profit center also determines the efficiency of the manager in charge of the center. A profit center helps in motivating managers to perform well in areas they control and also encourages managers to take initiatives. The profit center helps the organization to make the best use of specialized market knowledge of the divisional managers, and entrusts the local managers the responsibility of tradeoffs. Profit centers have been used as a major management control tool. The major advantages of profit centers are: • These help in increasing the speed of making operating decisions as they do not have to be referred to corporate headquarters.
• As the decision-making authority lies with the managers they can make better decisions related to the task they are performing, because they can understand the nature of the work better. • Since profit centers make their day-to-day decisions themselves headquarters can concentrate on broader issues of the organization. • Managers are motivated to perform more effectively, as they are responsible for increasing the profit of their unit. • Managers use their imagination, take initiatives to perform more effectively, to increase the profit of their unit. However, there are certain difficulties associated with the creation of profit centers. The management cannot have considerable control over the different profit centers when decisions are centralized. The top management has to depend on management control reports which may not be as effective as the personal knowledge of an operation. There may be no place for competent general managers in a functional organization because of lack of opportunities for them to develop creative management skills. Organizational units compete with one another, and this may, sometimes, result in conflict between different centers and reduction in cooperation between different units and sharing of resources.
TYPES OF PROFIT CENTERS
Functional units can be classified as different types of profit centers. A multi business company can be divided into independent profit generating units such as marketing, finance, manufacturing etc. The decisions regarding whether a
particular functional unit can be a profit center depends on the responsibility center manager's ability to influence, if not control, other activities that affect the company's bottom line. The different types of profit centers are discussed below: Marketing: A marketing activity becomes a profit center if it is charged with the cost of the products sold. A marketing activity can be given the responsibility of making profit when the marketing manager has the authority to make principal cost/revenue trade off in terms of marketing a product, spending on sales promotion, the appropriate time for this expenditure and on which media to spend. Manufacturing: This is an expense center and the management of activities here is based on performance against standard costs and overhead budgets. Problems in measurement may occur because of inadequate quality control, shipping of inferior quality products, and so on, to obtain standard cost credit. At times, there may arise the need to accommodate an order in-between production schedules, and the manufacturing managers may be reluctant to interrupt these schedules. In manufacturing units, when performance is measured against standards, there may be no incentives for manufacturing products that are difficult to produce. These factors may de motivate the managers, and eventually, they may not try to improve standards. Hence, while measuring the performance of manufacturing activities against standard costs, it is important to take into consideration quality control, production scheduling and the make or buy decisions.
Measuring profitability: Profitability measurements in a profit center can be of two types-management performance and economic performance. Management performance focuses on the manager’s performance while economic performance relates to how well a profit center is performing as an economic entity. Management performance is a measure used for planning, controlling and coordinating the day-to-day activities of the profit center. The performance
measures of profit centers can be different and hence, the necessary purpose for the information should not be obtained from a single set of data. For example, the management performance report can show excellent performance of a profit center manager. But the economic and competitive forces for that particular report can show poor economic performance. As a result, the center may run into losses and may even have to close shop.
TYPES OF PROFITABILITY MEASURES:
The parameters that can be used for measuring the profitability of a profit center are contribution margin, direct profit, controllable profit, income before taxes and net income. Contribution margin: This performance measure is used on the premise that, since fixed expenses are not controllable by the manager, the focus should rest on maximizing the difference between revenues and variable expenses. The problems of using contribution margin is that since many of the center’s expenses may vary according to the discretion of the profit center manager, focus on the contribution margin tends to direct the attention of the profit center manager away from the goals of the center.
Direct profit: This measure helps in understanding the contribution of the profit center to the general overhead profit of the corporation. It encompasses all the expenses directly incurred by profit centers or related to profit centers, irrespective of whether the expenses are controllable by the profit center manager. However, it does not include corporate expenses. Controllable profit: The headquarters expenses in an organization can be divided into two categories-controllable and uncontrollable. Controllable expenses include
expenses that are controlled by the business unit manager. The advantage of including such costs in the measurement system is that the profit will be calculated after the deduction of expenses that can be influenced by the profit center manager. Hence, these are controllable profits. As uncontrollable headquarters expenses are taken into consideration while calculating controllable profits, controllable profits cannot be compared directly with published data or with trade association data, which report the profits of other companies in the industry. Income before taxes: In this method, all corporate overhead profit is allocated to the profit center. The amount of expense incurred by each profit center forms the basis of allocation of profit. Such allotment has its own drawbacks. Firstly, the costs in departments like finance, and HR are not controllable by the profit center and hence, profit centers should not be held accountable for such costs. Also, it is difficult to quantify the amount that has been spent on human resources in each profit center. However there are certain advantages in allocating costs. Corporate service units often have a tendency to spend lavishly to make their units as excellent as possible without paying due attention to the value they create for the company. Once such costs are allocated to profit centers, the profit center managers will try to keep a check on the expenditure. The performance of profit centers is easily comparable to that of competitors’ performance who pay for similar services. Since the profit center can earn profit only when it has recovered all its costs, including allocated corporate overhead costs, the profit center manager will be motivated to make long-term marketing decisions such as pricing, product mix, and so on, because the center will have to recover its share of corporate overhead costs. For profit centers to function with the allocated costs in mind, it is important that they are allocated budgeted costs, and not actual costs. This ensures that the profit center managers will perform without complaining about the arbitrariness of the allocated costs, since there would be no variances in the allocated overheads in the performance reports.
Net income: The performance is measured by taking into consideration the net income after the payment of taxes. The disadvantage of using this method is that many decisions that have an impact on the income taxes are made at headquarters, and profit center managers should not be judged by these decisions. If the income after tax payment is constant percentage of the income before tax payment, then there would be no need to measure performance based on this method. This method would be useful if profit centers influence decisions like installing credit policies or disposing of equipment. This method is also useful to motivate the manager to minimize taxes in case the taxable income differs from income, as measured by using generally accepted accounting principles. The performance of profit centers can be measured by comparing actual results with one or more of the measures discussed above with budgeted amounts. In addition, data on competitors and industry provide a good crosscheck on the appropriateness of the budget. Investment centers An investment center has control over sales revenues and operating costs, and the assets used to generate profit. An investment unit manager must be in a position to influence the size of the investment and profit variables. An investment center is a measure of economic performance, and it analyzes all elements of profit and investment. The objective of this center is to maximize profit, given the amount of investment required to generate the profit. Cost centers The objective of cost center is to minimize the variance between standard costs and actual costs. A cost center is a production or service function, activity or item of equipment the costs of which may be attributed to cost units. Cost centers are basically related to costs, and not to the revenues or assets and liabilities of the organization. A cost center is a separate organizational unit for which separate cost allocation is done. A cost center forms the basis for building up cost records for
cost measurements, budgeting and control. From a functional point of view, a cost center is a production cost center (where only production is undertaken like a assembly department), a service cost center (offering service to production departments like personnel, accounting etc.,) or an ancillary manufacturing center (producing packing materials).
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