Responsibility Centers

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Responsibility Centers

What is a Responsibility Center?

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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 applying it scrupulously

Responsibility Centers further defined

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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

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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:

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Revenue Centers

Cost Centers

Profit Centers

Investment Centers

Responsibility Centers -

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Prime concern of the REVENUE CENTER – “TOPLINE”

1. Revenue Center -

Inputs (Money directly spent on achieving sales i.e. Mktg. Exp.)

Output (Sales Generated in money terms)

RC’sTASK

• 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.

Generate Sales

e.g. Marketing center

Revenue Center

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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.

Revenue Center - Issues

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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 CentersResponsibility centers whose employees control

costs, butDo not control their revenues or investment level.Examples: Production department in a

manufacturing unit, a dry cleaning businessTwo 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).

Cost/Expenses Center:Engineered Expenses V/s Discretionary Expenses

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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

Cost Center

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Decision Rights – Input Mix – Labor, Material, Supplies

Performance Measures – Minimize total cost for a fixed output Maximize output for a given “cost budget”

Typically used when – RC manager can measure output & quality of output knows cost functions, optimal input mix can set optimal quantity and appropriate rewards

3. Profit Center -

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Profit is most comprehensive measure of performanceFunction/Activity having highest influence on Bottom

Line suits best for Profit Center.Can be a Business Division or any of the functional unitDemands highest freedom/autonomy than any other

RCs’

Inputs (Money spent for earning profits)

Output (Money-profit Earned out of sales)

RC’sTASK

Relationship can be established

Profit Center

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Decision Rights – Input Mix – Labor, Material, Supplies Product Mix Selling Price

Performance Measures – Actual Profits Actual Profit in comparison with budgeted profits

Typically used when – RC manager has knowledge about correct

price/quantity RC manager has knowledge to select optimal

product mixCANDIDATES FOR PROFIT CENTER ……………

3. Business Unit as Profit Center

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Business Units In a Decentralized CompanyBest 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 CenterCharge cost of production to revenue center Grant of maximum autonomy to the unitDelegate sufficient authorityTreat the unit as a mini company

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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. Functional Unit as Profit Center3. Functional Unit as Profit Center

3. Profit Center – Performance Measures

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2. Direct Profit Less Fixed Expenses

All Expenses incurred at the behest of PC

• RevenueLess 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 expensesincurred to run a company ; e.g.All administration, financing and tax planning activities are carried at HQ

Less Income tax

5. Net ProfitIn some cases RC do have impact on tax liability of the company - Tax Heavens

Performance Measure Justification

3. Profit Center - Advantages

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• 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

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• 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 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

Responsibility Centers

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4. Investment Centers –

Inputs (Money spent for Starting & running the business)

Output (Money/net profit Earned on account of investment)

RC’sTASK

• 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

Investment Center

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Decision Rights – Input Mix – Labor, Material, SuppliesProduct MixSelling PriceCapital Investment

Performance Measures – Actual ROI Actual Residual Income i.e. EVAActual ROI & RI in comparison with budgeted ROI & RI

Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix RC manager has knowledge about investment

opportunities

Return on Investment –

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Return on Investment-

Relating the profits of a firm with the investment made.

1. Return on Assets - ROA

2. Return on Capital Employed - ROCE

3. Return on Shareholder’s Equity - ROE

ROI can be computed in many different ways depending upon the need and relevance.

Return on Investment – Return on Assets

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Net Profit

1) Return on Assets = --------------- * 100

AssetsROI 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

Return on Investment – Return on Capital

Employed

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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

Return on Investment – Return on Shareholders’

Equity

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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

Economic Value Added - EVA® (Stern & Stewart)

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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

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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

Return on Investment V/s Economic Value Added

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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.


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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)


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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.


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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

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Economic Value Added

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A simple summary of the responsibility centers

Revenue CenterOutput 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

Responsibility Centers

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