responsibility centres

1. Taban Rashid
0774-815179
Responsibility Centers & Financial
Control
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2. INTRODUCTION
In small organizations, decision making &
management is often by a single or few individuals
As organizations grow, complexities arise
Companies facing challenges due to increased
competition
This necessitates effective control & mgt of various
operations
2

3. Introduction cont …
Challenges of competition met by recognizing
three key principles
–Delegation of responsibility to specific successive
lower levels of the organization
–Motivation of the level of management to which a
certain task has been delegated
–Measurement of achievement of the specified
objectives
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4. INTRODUCTION
Need to share authority and responsibility
Need for divisionalization and segmentation
Delegation of a person in charge of a division or
segment (ma lagers)
Persons may be held responsible for consequences of
their decision making
This requires establishment of responsibility centres
in the organization
4

5. Introduction cont …
Responsibility centres:
–An area of responsibility which is controlled by an
individual
–An activity, such as a department, that a
manager controls
–a sphere of activity in which is a personal
responsibility of the manager for the
performances, which he controls.
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6. Introduction cont …
These require established system of
accumulation, absorption and allocation of costs
to identifiable responsibility centres
A responsibility centre is thus an organization
unit headed by a responsible manager
A company is a collection of responsibility
centres
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7. Responsibility centres
Responsibility centres evaluated on the basis of
set criteria;
–Comparison with budgets and targets
–Comparison among different divisions within
the company
–Comparison with historical results
–Comparison with industry averages
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8. Characteristics of a responsibility centre
Clearly defined segment of an organization
A designated individual is responsible for its
performance eg output produced, inputs
consumed
The designated individual has the necessary
authority to discharge the assigned
responsibilities
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9. Classifications/ types/ forms of
responsibility centres
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10. Cost/ expense centre
A segment/ division of an organization whose
manager is responsible for costs incurred in that
segment but not revenues.
A cost center can be relatively small
The head of the cost center is responsible for the
quantity and quality of goods produced or
services provided
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11. Cost/ expense centre
Responsible for costs that are controllable by them &
their subordinates
Engineered costs: can be predicted with fair degree of
accuracy eg cost of r/materials, direct labour, water,
electricity etc
Discretionary costs: for which output can’t be
measured in monetary terms eg administrative &
support units like accounts, legal, R&D
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12. Cost/ expense centre
Its financial responsibility is to control and report
costs only.
The performance of responsibility centre is
evaluated by comparing the cost incurred with the
budgeted cost.
12

13. 2. Revenue centre
This centre is primarily responsible for generating
sales revenue.
It doesn’t possess control over cost, investment in
assets, but over some of the expenses of marketing
department.
Performance is evaluated by comparing actual
revenues with budgeted revenues and budgeted
marketing expenses with actual marketing expenses
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14. 3. Profit centre
A segment of a business responsible for both
revenues & expenses
Its primary objective is to earn targeted profit
More concerned with increasing centre revenues
Evaluated on whether the centre has achieved
targeted or budgeted profit
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15. 4. Investment centre
A segment whose manager is responsible not only for
revenues and costs, but also for the investment required
to generate profits.
It is responsible for returns on investment
Required to control the amounts invested in the Centre's
assets
Has more authority and responsibility than the manager
of either cost centre or profit centre
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16. Establishing or designing a responsibility
centre
This must be carefully planned and executed; steps
include;
–Study the organization structure, authority-
responsibility r/ship, job descriptions, layout of the
factory & office, various activities, pdn process &
structure of pdn flows, and the interrelationships
between these different activities
–Define each activity in descriptive terms
16

17. Establishing or designing a responsibility
centre
–Evaluate the need for any reorganization
required in the context of establishment of
responsibility centres & develop an
organization structure on the lines of
desired responsibility centres
–Delineate the organization into various
responsibility centres
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18. MANAGEMENT METHODS
 Organizations with various responsibility centres usually
practise two methods in managing the organization’s
activities that become more complex.
–Centralization management : decision is made by the top
management and later delegate to the middle and lower
management has to be implemented.
–Decentralization management: , the lower management is
given the opportunity to make plans and implement decisions
placed under their responsibility
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19. Advantages of decentralization
Encourage prompt actions to fulfil public’s need.
Speed up the decision-making process.
Encourage training and improve manager’s
motivation.
Enable top management to concentrate on
more important tasks.
Encourage competition.
Better access to local information
19

20. Decentralization in Organizations
Disadvantages of
Decentralization
Lower-level managers
may make decisions
without seeing the
“big picture.”
Lack of
coordination among
autonomous
managers.
Lower-level manager’s
objectives may not
be those of the
organization.
Difficult to
spread innovative ideas
in the organization.
Create overlapping
of activities

21. Measuring the Performance of Investment
Centers
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Return on Investment (ROI)
Residual Income (RI)
Economic Value Added (EVA)

22. Measuring the Performance of Investment
Centers
Return on investment (ROI): the most common measure
of performance for an investment center
22
ROI =
Operating income (EBIT)
Average operating assets
= Operating income
Sales
X Sales
Average operating
assets
=
Operating income Operating asset
margin turnover
X

23. Components of ROI
Margin expresses the portion of sales that is available
for interest, income taxes, and profit.
=
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑠𝑎𝑙𝑒𝑠
Turnover shows how productively assets are being used
to generate sales.
=
𝑠𝑎𝑙𝑒𝑠
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
23

24. There are three ways to increase ROI
Increase
Sales
Reduce
Expenses
Reduce
Assets

25. Advantages of ROI
Encourage the manager to focus on the relationship
between sales, expenses and investments.
Encourage the manager to focus on the effective use of
cost.
Encourage the manager to focus on the effective use of
assets.
It discourages excessive investment in operating assets.
25

26. Drawbacks of ROI
The manager tends to ignore division’s profitability. This
attitude leads to negative impacts on the company’s overall
profitability.
The manager tends to focus on the short-term expenses,
whereas ignoring long-term expenses.
In the absence of the balanced scorecard, management may
not know how to increase ROI.
 Inheritance of many committed costs
26

27. Year 1:
Sales $30,000,000 $117,000,000
Operating income 1,800,000 3,510,000
Average operating assets10,000,000 19,500,000
ROI 18 % 18 %
Year 2:
Sales $40,000,000 $117,000,000
Operating income 2,000,000 2,925,000
Average operating assets10,000,000 19,500,000
ROI 20 % 15 %
Comparison of ROI
Snack Foods
Division
Appliance
Division

28. Margin 6.0 % 5.0 % 3.0 % 7.5 %
Turnover x3.0 x4.0 x6.0 x6.0
ROI 18.0 % 20.0 % 18.0 % 15.0 %
Margin and Turnover
Comparison
Snack Foods
Division
Appliance
Division
Year 1 Year 2 Year 1 Year 2

29. RESIDUAL INCOME (RI)
RI is the division’s operating income after deducting the
interest on the capital.
 The difference between operating income and the
minimum dollar return required on a company’s
operating assets
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 
Residual Operating Minimum rate of return
= -
Income Income Operating assets


30. Comparison of ROI & Rl
• ROI measures net operating income earned
relative to the investment in average
operating assets.
• Residual income measures net operating
income earned less the minimum required
return on average operating assets.

31. Illustration
•The Retail Division of link Co. has average operating
assets of $100,000 and is required to earn a return of
20% on these assets. In the current period, the division
earns $30,000.
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Operating assets 100,000
$
Required rate of return × 20%
Minimum required return 20,000
$
Actual income 30,000
$
Minimum required return (20,000)
Residual income 10,000
$

32. Motivation of RI
Residual income encourages managers to make
profitable investments that would be rejected by
managers using ROI.
Easy to calculate and understandable.
Profitability and capital (assets usage) information used
to calculate RI can be easily obtained from the company
accounting records.
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33. Drawbacks of RI
Since RI is stated in absolute number and not in
percentage form, RI is less suitable to be used in
making comparisons.
Inaccurate comparison between responsibility
centres producing different products
It does not discourage myopic behavior
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34. Illustration
34
Div A Div B
Average operating assets $15,000,000 $2,500,000
Operating income $ 1,500,000 $ 300,000
Minimum returna 1,200,000 200,000
Residual income $ 300,000 $ 100,000
Residual returnb 2% 4%
a0.08 × Operating assets.
bResidual income divided by operating assets.

35. Economic Value Added
is a specific type of residual income calculation that has
recently attracted considerable attention.
It is the division’s operating income after tax minus the
capital employed cost.
Capital employed cost = weighted average capital cost *
total capital employed
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Economic Value Added
(EVA) =
Division’s Operating Income
After Tax
Weighted Average Capital Cost x
Total Capital Employed
_

36. 36
Illustration
Amount Percent
After-Tax
Cost
Weighted
Cost
Mortgage bonds 2,000,000
$ 13.3% 0.0480 0.006
Unsecured bonds 3,000,000 20.0% 0.0600 0.012
Common Stock 10,000,000 66.7% 0.1200 0.080
Total Sources 15,000,000
$
Weighted average cost of capital 0.098
Capital employed 15,000,000
$
Cost of capital 1,476,000
$

37. The DuPont model
A financial ratio based on the return on equity
ratio
To analyze a company’s ability to increase its
return on equity
The model breaks down the return on equity
ratio to explain how companies can increase
their return for investors.
37

38. The DuPont model
Return on Equity (ROE) is the measure of the profitability of a
business entity in relation to the equity.
Measures how well the business is doing in relation to the
investment made by its shareholders.
It tells the shareholders how much the company is earning for
each of their invested dollars.
ROE = It is calculated by dividing a company’s earnings after
taxes (EAT) by the total shareholders’ equity, and multiplying the
result by 100%.
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39. The DuPont model
3 components;
–Profit margin
–Total asset turnover
–Financial leverage
The model concludes that a company can raise its ROE
by maintaining a high profit margin, increasing asset
turnover, or leveraging assets more effectively.
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40. The DuPont model
ROE = Profit margin * Total asset turnover * Financial
leverage
But
Profit margin =
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔
Total assets turnover =
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
Financial leverage =
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
𝑻𝒐𝒕𝒂𝒍 𝒆𝒒𝒖𝒊𝒕𝒚
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41. ILLUSTRATION
Given two companies A and B, operating in the same
apparel industry and have the same return on equity
ratio of 45 percent. This model can be used to show the
strengths and weaknesses of each company. Each
company has the following ratios.
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Ratio A B
Profit Margin 30% 15%
Total Asset Turnover .50 6.0
Financial Leverage 3.0 .50

42. Management Control Systems
A system designed to influence subordinates to act in the
organization’s interest
–Used by principals (owners) to influence agents’
(managers’) behavior
–It guides the behavior of managers and employees.
Involves
–Delegated decision authority
–Performance evaluation and measurement
–Compensation and reward decision
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43. 11-43
Balancing the Elements
The goal of the organization is to make money.
The goal of the subordinate manager is to make
money.
An effective management control system
influences the subordinate manager
through compensations and rewards to
make decisions that make money for the
organization.

44. Setting Goals, Objectives, and
Performance Measures
Top management develops organization-wide
goals, measures, and targets. They also identify
the critical processes needed to achieve the goals.
Top management and critical process managers
develop key success factors and performance
measures. They also identify specific objectives.

45. Setting Goals, Objectives, and Performance Measures
Critical process managers and lower-level
managers develop specific performance
measures for each objective.

46. Organizational Goals
A well-designed management control system
aids and coordinates the process of making
decisions and motivates individuals throughout
the organization to act in concert.

47. The transferred good is
revenue to the selling
division and cost to the
buying division. This
value is called transfer
pricing.
Transfer Pricing


48. Transfer Pricing
Some major issues;
–Impact on divisional performance measures
–Impact on firm wide profits
–Impact on divisional autonomy
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49. Transfer pricing
Transfer pricing should help achieve a company’s
strategies and goals
fit the organization’s structure
promote goal congruence
promote a sustained high level of management
effort
49

50. Transfer Pricing (pricing methods)
Market price
Negotiated transfer prices
 cost-based transfer prices
–Variable pricing
–Full (absorption cost based) pricing
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51. Transfer pricing
The Small Motors Division is operating at 70 percent capacity. A
request is received for 100,000 units of a certain model at $30 per
unit. Full manufacturing cost of the motor, broken down as
follows:
Direct materials $10
Transferred-in part 8
Direct labor 2
Variable overhead 1
Fixed overhead 10
Total cost $31
51
Should the Parts Division
lower the transfer price to
allow the Motor Division
to accept the special order?

52. Direct materials $10
Transferred-in part 8
Direct labor 2
Variable overhead 1
Fixed overhead 10
Total cost $13
The division could pay as much as $17 for the component and still break
even on the special order
Transfer pricing

53. Negotiated Transfer Prices
When imperfection exists in competitive markets for the
intermediate product, market price may no longer be
suitable.
In this case, negotiated transfer prices may be a
practical alternative. Opportunity costs can be used to
define the boundaries of the negotiation set.
53

54. Disadvantages of Negotiated Transfer
Prices
One division manager, possessing private
information, may take advantage of another
divisional manager.
Performance measures may be distorted by the
negotiating skills of managers.
Negotiation can consume considerable time and
resources
54

55. Despite the disadvantages,
negotiated price transfer prices offer
some hope of complying with the
three criteria of goal congruence,
autonomy, and accurate
performance evaluation.

56. Other Cost-Based Transfer Pricing

56
Full –cost
transfer
pricing
Full cost plus
mark up
Variable cost
per fixed fee

57. Comparison of methods
57
Achieves Goal Congruence
Market Price: Yes, if markets competitive
Cost-Based: Often, but not always
Negotiated: Yes