Responsibility Accounting

Lecture 2
 Lecture Objectives
After completion of this session, you should be able to:
1. Understand the principles of responsibility accounting.
2. Explain why establish accountability according to the
responsibility delegated to various levels of management.
3. Explain various decision centres available in organisations and
be able to trace costs to the individual managers responsible for
making decisions.
DIVISIONALISATION
 DIVISIONALISATION
• For growth reasons or when organisations become more product diversified
decentralisation or divisionalisation of activities may take place.
• Decentralisation entails transfer or delegation of authority for decision
making to other levels of management and may lead to divisionalisation.
• e.g. division of business into autonomous regions or products, services,
target customers – SAMSUNG
– Product-type divisional organisation structure e.g. Consumer electronics; Device Solutions; IT &
Mobile Communications
– Centralised Corporate Hierarchy – The Corporate HQ ensuring that the operations are unified and
effectively directed towards growth and operational effectiveness.
– Geographical Groupings e.g. Samsung Electronics North America is a geographical division within
Samsung Electronics, which is a product-type division
 DIVISIONALISATION
• Managers are allowed to run their part of the business as though their own
company.
• They are given authority to make decisions without reference to senior
management.
• Each division may have responsibility for revenue, costs, or profit.
Divisions are held responsible and performance evaluation is based on
these basis.
• For control purposes, it is critically important that the performance
measures are designed well.
DIVISIONAL
STRUCTURE
RESPONSIBILITY ACCOUNTING
• An accounting system that provides information on responsibilities of
individual managers for performance evaluation based on controllable items.
– In a system where an organisation is broken up into sub-units known as responsibility centres.
• It involves:
– identifying responsibility centres and their objectives
– developing performance measurement schemes
– preparing and analysing performance reports for the responsibility centres.
– distinguishing managerial controllable items from uncontrollable ones. i.e. based on
Controllability principle
 BASIC PRINCIPLES OF R.A.
• Organisation structure – clearly defined + delegated
responsibility for clearly mapped out individual roles
• Functional control – extent and boundaries are clearly defined
• Regular performance reports – served to responsible
individuals
• Distinguishing managerial controllable items from
uncontrollable ones. i.e. based on Controllability principle
CONTROLLABILITY PRINCIPLE
• Costs and Revenues – allocated to responsibility centres
depending on whether controllable or uncontrollable.
• Controllable Cost: Manager and their department should
be charged only with costs they significantly influenced.
RESPONSIBILITY CENTRES
• May be defined as “a segment of an organisation where an
individual manager is held responsible for the segment’s
performance” (Revenue or cost or both).
– Drury, 4th edition p.47
• There are four managerial units based on cost allocation and
profit measurement.
– Cost centre
– Profit centre
– Investment centre
– Revenue Centre
 COST CENTRE
• A business segment that incurs expenses ONLY and no
generation of revenue e.g. production cost centre, service cost centre,
manufacturing centre, HR department.
• Managers are accountable for the expenses under their control
• Performance Evaluation
– Cost control
– Quantity and quality of services
– Variance analysis (budgeting, standard costing)
– Efficiency analysis
 PROFIT CENTRE
• A business segment with control over BOTH revenues
(sales) and costs but no control over investment decisions
and funds.
• e.g. a division or restaurant in a large chain + responsible for
the production and sale of a product
• Performance Evaluation
– Profitability
– Achievement of budgeted profit
 INVESTMENT CENTRE
• A business segment with control over revenues (sales), costs
(controllable) and amount of investment in fixed and current
assets undertaken; sales prices, output volumes, etc.
• Profit earned must be related to capital investment
• Performance Evaluation
– Return on Investment (ROI)
– Residual Income (RI)
– Return on Capital Employed (ROCE)

Dr Israel Nonyerem Davidson Newcastle Business School

CCE- 447 . isreal.davidson@northumbria.ac.uk City Campus East
 REVENUE CENTRE
• Responsible for achieving Revenue only + Limited
managerial autonomy e.g. Regional Sales Teams:
– May be responsible for costs of salespersons, expenses etc, but
not cost of products
• Performance Evaluation
– Sales Volume or £
– Sales within Time Periods
– Sales Budgets

Dr Israel Nonyerem Davidson Newcastle Business School

CCE- 447 . isreal.davidson@northumbria.ac.uk City Campus East
Investment Centres CORPORATE HQ
(CEO)

OPERATIONS FINANCE DEPT. HR DEPT. LEGAL DEPT

(DIRECTOR) (FINANCE DIRECTOR) (FINANCE DIRECTOR) (DIRECTOR)

PRODUCT A PRODUCT B PRODUCT C

Profit Centres (MANAGER) (MANAGER) (MANAGER)

Bottling Plant Warehouse Distribution

Cost Centres (MANAGER) (MANAGER) (MANAGER)
ADVANTAGES OF R/ACCOUNTING
• Conditions a clear definition and communication of corporate objective
and individual goals.
• Compels setting of realistic plans and budgets
• To provide a basis for evaluating the quality of the divisional manager’s
performance.
• Focuses managerial attention on key areas or issue requiring immediate
attention
• A system of closer control of individual managers. To strengthen internal
control and improve operational efficiency.
RESPONSIBILITY PERFORMANCE
EVALUATION SYSTEMS
(REVIEW)

ROI vs RI
RETURN ON ONVESTMENT (ROI)
• ROI – the relationship between profit and the investment
that generates the it.
• This is the ratio of income to the investment employed
in generating the income (Net Income):

TURNOVER

MARGIN
 ROI - EXAMPLE

• Apple Plc reports the following financial results in 20X1

Net Income £ 400,000
Sales £18,000,000
Investment £ 5,000,000
Example - Working

Compare with plan,

previous years,
competition, etc.
 Example - Workings
TO IMPROVE ROI:

1. Increase sales
2. Control costs
3. Reduce
investment

TURNOVER

MARGIN
ROI = 8%
 ROI – EXAMPLE 2

• In the second quarter, Apple Plc was able to increase sales

to £20,000,000 resulting to an increase in net profit to
£500,000. Investment remained the same at £5,000,000.

• Calculate the new ROI

 LIMITATIONS OF ROI
• Measures profitability against book value of assets. Therefore
businesses with depreciated assets will have high ROI.
• May influence divisional managers to opt only for investments with
high rates of return and reject project that would reduce ROI though
capable of increasing the value of the business. (Kaske et al, 2012)
• May focus managerial attention on short-term results and profitability
while ignoring long-term profitability focus.
• Senior management rely heavily on financial metrics; however financial
metric such as ROI is unable to capture and report non-financial
performance indicators. (Kaske et al, 2012)
 RESIDUAL INCOME (RI)
• RI – The Net income an investment can earn above the
threshold or minimum rate of return (time-deposit interest
rate) assigned to the investment.
• Formula:
• Operating income xxx
• Less minimum required Rate of Return xxx
• Residual income xxx
 RESIDUAL INCOME - Example
• Apple Plc has invested £5 million in the assets of its Lagos subsidiary. As an investment
centre, the facility’s performance is evaluated based on its return of 6% on invested
funds. In the 20x1 financial year, the Lagos subsidiary generated net income of £500,000
amounting to 10% return on investment.
1. Calculate the Residual Income and comment on performance.
2. What if the manager of the Lagos subsidiary wishes to invest £500,000 in a new
equipment that will generate a return of £40,000 per annum.
1. Compute performance based on ROI
2. Computer performance based on RI
3. The manager’s performance is evaluated based on ROI. Consider if the Lagos
subsidiary manager will accept or reject the new project and why.
 Example Q1
RI = Net operating income - (Minimum Required Return x Cost of Operating Assets)

Net operating income £500,000

Investment £5,000,000
Minimum required return 6%
Minimum required return (6% x £5m) £ 300,000

Net operating income £ 500,000.00

Minimum required return £ 300,000.00
Residual Income £ 200,000.00
 Example Q2 - ROI

Lagos Subsidiary Investment - New Equipment

£
Investment cost 500,000
Net income 40,000
ROI (£40,000/500,000) 8%
Note : Divisional ROI in 20x1 10%
 Lagos Subsidiary Investment - New Equipment

Example 2 Q3/4 - RI
Net operating income £40,000
Investment £500,000
Minimum required return 6%
Minimum required return (6% x £5K) £ 30,000
Net operating income £ 40,000.00 Accept
Minimum required return £ 30,000.00 project
Residual Income £ 10,000.00

ROI £
Investment cost 500,000 Reject
project
Net income 40,000
ROI (£40,000/500,000) 8%
Note : Divisional ROI in 20x1 10%
 Residual Income
Advantages:
• Encourages divisional managers to make investments if they contribute to residual
income.
• An absolute measure (profitability) in money terms. This is highly useful for profit
motive organisations.
• Easily calculated.
• Encourages goal congruence where linked to reward.

Limitations
• Takes no account of relative profitability or size of each division
• Absolute measure of profitability – comparison can be difficult where size of
investment differs.
Terminologies Covered
• Divisionalisation
• Decentralisation

Familiarise self with these

• Responsibility Accounting

Business terminologies
• Responsibility Centres:
– Cost centre
– Revenue Centre
– Profit Centre
– Investment Centre
• Controllable Costs and Revenues
• Return on Investment (ROI)
• Residual Income (RI)
• Goal Congruence
• Drury, C., 2015, Management and Cost Accounting 9th Edition, Cengage Learning
• Drury, C., 2016, Management Accounting for Business 6th Edition, Cengage
Learning
• Armstrong, A., 2016, Mike Ashley Admits Sports Direct has “Outgrown Me”, The
Daily Telegraph http://www.telegraph.co.uk/business/2016/06/07/mike-ashley-
admits-sports-direct-has-outgrown-me/
• The FT, 2016,
http://www.ft.com/cms/s/0/ed8fa5a4-2c97-11e6-a18d-a96ab29e3c95.html#axzz4Bj
xGp93e
• Kaske, F., Kugler, M., Smolnik, S.: Return on investment in social media – does the
hype pay off? Towards an assessment of the profitability of social media in
organisations, in Proceedings of the 45th Hawaii International Conference on
System Sciences, 3898-3907 (2012)