Responsibilitycentersfinal 130122112204-phpapp01

Responsibility Centers
Saalim sadique shaikh
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
2 wwwa.pmapnalgyeminengtv ikiatl ps.cco.rinupulously

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

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

Revenue Center
A 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.

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

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
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

11
Cost Center
Inputs
(Money spent on
production)
RC’s
TASK
 Input Mix – Labor, Material, Supplies
 Minimize total cost for a fixed output
 Maximize output for a given “cost budget”
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

12
2. Expenses Center –
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

13
2. Expenses Center –
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.

14
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.

15
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 -

16
3. Profit Center -
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

Profit Center
17
 Product Mix
 Selling Price
 Actual Profits
 Actual Profit in comparison with budgeted profits
 RC manager has knowledge about correct price/quantity
 RC manager has knowledge to select optimal product mix
CANDIDATES FOR PROFIT CENTER ……………

18
3. Business Unit 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

19
3. Functional UUnniitt 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

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

21
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.

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

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

24
Investment Center
Product Mix
Selling Price
Capital Investment
 Actual ROI
 Actual Residual Income i.e. EVA
Actual ROI & RI in comparison with budgeted ROI & RI
 RC manager has knowledge about correct price/quantity
 RC manager has knowledge to select optimal product mix
 RC manager has knowledge about investment opportunities

25
Return on Investment –
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

26
Return on Investment – 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

27
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

28
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

29
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

30
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

31
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.

32
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)

33
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.

34
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
35

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 $100,000
Operating income $ 10,000 $ 10,000 $ 20,000
Assets invested $ 25,000 $ 12,500 $ 25,000
Desired 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 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

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%

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 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

Computing EVA for HLL
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

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.

Solution
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. 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`

Identify the most appropriate 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

Solution
1. A pizza 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

A simple summary of 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

Responsibilitycentersfinal 130122112204-phpapp01

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Viewers also liked

Viewers also liked (10)

Similar to Responsibilitycentersfinal 130122112204-phpapp01

Similar to Responsibilitycentersfinal 130122112204-phpapp01 (20)

Recently uploaded

Recently uploaded (20)

Responsibilitycentersfinal 130122112204-phpapp01

Editor's Notes