Responsibility Centers

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Responsibility Centers
Chapter 4 and 5
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An important component of Management Controls
Assigning responsibility for executing strategy

• Implementing strategies is not adequate if
  individuals who must execute them fall short.

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Therefore, management controls must include

• How responsibility is assigned and measured
• How tasks are measured (not necessarily tasks
  done by humans but also by machines e.g. units
  produced)
• Task controls such as when to order inventory,
  why the actual differ from budgeted (the causes)
• And, not easy to measure or quantify items such
  as impact on behaviors, intangible assets, and so
  on.

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Responsibility Centers
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What is a responsibility center?

• In simple words an organizational unit for which
  a manager is made responsible.
• Examples A specific store in a chain of grocery
  stores.
• A work-station in a production line manufacturing
  automobile batteries.
• The payroll data processing center within a firm.

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Attributes of a responsibility center

• It is like a small business, and its manager is
• Asked to run that small business and preserve the
  interests of the larger organization.
• Goals for the center should be specific and
  measurable, and
• Should promote the long terms interests of the
  organization and should be compatible with other
  responsibility center activities.

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Example A courier service (DHL)

• Courier operations dispatch trucks to pick up or
  deliver shipments from local terminals.
• It could be sent to one or more central terminals
  and then sorted and redirected.
• Success of this service would depend on
• Service commitment to customers (on time, without
  damage) and
• Controlling costs
• Let us suppose that each terminal is treated as a
  responsibility center.
• How should the company measure the performance of
  each terminal, its mangers, and its employees?

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Measuring the performance of the
courier-terminal responsibility center

• To focus on efficiency we could measure no. of
  parcels picked up, sorted or delivered, per
  route, per employee, per vehicle, per hour or per
  shift.
• To focus on customer service, we could measure
  each groups contribution to customers
  proportion of the time the terminal met its
  deadlines, when terminals are required to sort
  shipments, what the sorting error rate was.
• We could also measure customer service by no. of
  complaints operations group receives, average
  time taken by the operation group to respond to
  complaints, and no. of complaints of poor, or
  impolite service.

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Measuring inputs and outputs

• In the courier example, the inputs are causal and
  direct e.g. no. of packets received to time
  taken to deliver them.
• But, such causal and direct relationships are not
  always possible. For example, how does
  advertising contribute to increase in revenues?
• Or, how would you measure the contribution of R
  D to product innovation, revenue generation, or
  cost reduction?

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Converting the inputs into monetary units

• Most organizations would convert the physical
  inputs into monetary units when evaluating a
  responsibility center.
• No. of units x cost of production, labor hours x
  per hour rate, etc.

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Measuring outputs

• Measuring outputs is more difficult. This is
  because
• Input may be extended this year but outputs
  (benefits) may be received over several years
  (e.g. employee training).
• It would be difficult to make the causal
  relationship e.g. marketing expenses, IT
  investments, accountants and generation of
  revenue and profits.

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The input-output attributes

• Most organizations use financial controls cost,
  revenue, and profits, etc.
• However, such measures are not applicable to all
  units within an organization.
• For example, how would you measure the
  contribution of a production department? It can
  only be done on a cost measurement basis.
• How would you measure the contribution of a sales
  department only by revenue generated.

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Why does an organization relate input to outputs?

• Because they inherently measure efficiency and
  effectiveness.
• Efficiency ratio of output to inputs
• Caution Do not use ratio of output to input in
  an absolute sense but, only in a comparative
  sense.
• If Dept. A is more efficient than Dept. B, do not
  rush to conclusions examine why Dept. B is less
  efficient and what can be done about it.
• Also, comparisons are possible only if Dept. B
  and Dept. A use comparable outputs and comparable
  inputs. You cannot compare advertising to
  accounting.

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Efficiency

• Efficiency is generally measured by comparing
  actual costs to standard costs.
• Issues
• Standard costs do not remain stationery.
• Recorded costs are often different from actual
  resources (costs) consumption.
• Lesson Establishing a responsibility center is
  easy Measuring its efficiency in a reasonable
  manner is difficult.

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Effectiveness

• Relationship between a responsibility centers
  output and its objectives (what it was intended
  to do or perform or deliver).
• If the output contributes to satisfying the
  objectives, the more effective it is.
• The new advertising and marketing efforts has
  increased awareness and recognition of our
  product. Advertising and marketing has been
  effective.

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Efficiency-EffectivenessNot a compromise

• A responsibility center must both be efficient
  and effective.
• It must use the least amount of inputs to get the
  maximum amount of output and yet deliver on the
  goals.
• A sales department was efficient in growing the
  sales by 10 without adding additional sales
  people or marketing expenses (efficient)
  however, many of the credit sales could not be
  collected (bad debts). It is ineffective.

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Role of Profit

• The goal of every for-profit organization is earn
  profits (effectiveness).
• If the organization could use the least input to
  get the maximum earnings, profits will be high
  (efficiency).
• Therefore, profit is an indicator of both
  efficiency and effectiveness.
• However, not every unit within an organization
  earns profit and therefore, this measure cannot
  be used for all responsibility centers.
• Therefore, an organization must establish various
  types of responsibility centers.

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Types of Responsibility Centers

• Revenue Centers
• Cost Centers or Expense Centers
• Profit Centers and
• Investment Centers

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Revenue Centers

• Responsibility Centers whose members control
  revenues but,
• Not the manufacturing or acquisition cost of the
  products or service they sell, or
• The level of investment in the responsibility
  center.
• In other words, you cannot link the input to the
  output.

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Revenue Centers (continued)

• Most revenue centers may not set selling prices
• They definitely have no control over the costs of
  input acquired (service manager of an automobile
  workshop does not control gasoline costs)
• These centers are generally not allocated costs
  of the goods that they market (there are
  exceptions). Manager is responsible only for
  costs directly incurred by his/her unit.
• They are evaluated on the basis of actual sales
  or orders booked against budgets or quotas and
• Example a unit of a chain store in a mall.

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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).

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Engineered costs

• Should be measurable in monetary terms, outputs
  in physical quantities.
• Works well in units such as production,
  distribution, accounting receivables, payables
  where repetitive tasks are performed.
• Developing standard costs for such activities is
  more reliable than in other cases.
• Multiply standard cost per unit x no. of units
  produced or processed this is the ideal cost.
• Compare it to actual costs and the difference is
  indicative of efficiency or lack thereof.

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Engineered costs Important to remember

• The fundamental purpose of all responsibility
  centers is accountability evaluating
  performance. And a engineered cost center,
• Does not merely compare costs but also
• Holds the managers accountable for
  obtaining/producing right quality of product
• Volume of production, speed of processing.

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Discretionary costs

• Mostly administrative and support service costs
• More difficult to measure in physical quantities
  or precisely on monetary terms (e.g. customer
  relations or even R D).
• Discretionary means, management allocates them
  based on established polices (not arbitrarily).
• More caution is required while using discretion
  cost numbers.
• Difference between budgeted expenses and actual
  expenses does not indicate efficiency.
• Suppose if the actual cost is less than budget,
  does it mean good or bad?
• Suppose if the actual cost is higher than budget,
  does it mean good or bad?

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Expense centers (continued)Comparing Budgeted
and Actual Costs

• Budgeted costs are target estimates.
• It points to a goal to be achieved.
• But, it is not written in concrete.
• Actual costs are that were incurred during a
  given period.
• The difference between the two could be either
  positive or negative variances.
• However, making conclusions on the basis of
  positive or negative variances must be done
  carefully.
• See the next set slides and the example.

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Morton Carpets Master Budget (Fixed)
Prod. 1 Prod. 2 Prod. 3 Prod. 4 Total
Units made 245,000 385,000 636,000 1,250,000
Units per batch 500 2,500 1,500 5,000
No. of batches 490 154 424 250
Cost per unit 5.40 3.20 4.25 1.45
Cost per batch 325.00 680.00 400.00 135.00
Unit-related costs (245,000x5.40) 1,323,000 1,232,000 2,703,000 1,812,500 7,070,500
Batch-related costs (490x325) 159,250 104,720 169,600 33,750 467,320
Prod.-sustaining costs 125,000 168,000 256,000 355,000 904,000
Facility costs 1,450,000
Total cost center costs 9,891,820
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Morton Carpets Actual Costs
Prod. 1 Prod. 2 Prod. 3 Prod. 4 Total
Units made 2,945,000 345,000 675,000 950,000
Units per batch 600 2,300 1,800 6,000
No. of batches 492 150 375 159
Cost per unit 5.43 3.18 4.33 1.40
Cost per batch 335.00 670.00 387 144.00
Unit-related costs 1061,850 1,097,100 2,922,750 1,330,000 6,951,700
Batch-related costs 164,820 100,500 145,125 22,896 433,341
Prod.-sustaining costs 133,000 163,000 259,000 362,000 917,,000
Facility costs 1,650,000
Total cost center costs 9,952,041
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Morton Carpets - Variance Analysis
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What do we learn from the variance analysis of
Morton Carpets?

• The variance analysis presents a mix of positive
  and negative variances.
• Example Product 1 and 3, unit-related costs were
  higher than planned, and
• For products 2 and 4 they were lower than
  planned.
• In total, the unit-related costs and
  batch-related costs were lower than planned and
  the product-sustaining and facility-sustaining
  costs were higher than planned.

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What can we conclude aboutMorton Carpets?

• Based on initial analysis, manufacturing is able
  to control unit-related and batch-related costs,
  but
• Did not do so well controlling product-sustaining
  and facility-sustaining costs.
• A closer examination, however, casts doubts on
  these conclusions.
• If you look at slides 24 and 25, you will notice
  that the no. of units actually made differed from
  budgeted for all four products.
• Similarly, no. of units per batch actually
  produced differed from budgeted units per batch.
• Because of these volume differences, it is
  inappropriate to compare the cost targets in the
  master budget with actual cost results.

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What can managers do to make the numbers
comparable and meaningful?

• Use a flexible budget (the text does not use this
  term but discusses the same concepts within cost
  variability and incremental budgeting sections).
  The objectives are the same.
• Flexible budget recasts cost targets in the
  planned or budget to reflect the achieved level
  of production.
• The flexible budget develops cost target levels
  based on actual level of activity.
• See the next set of slides.

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Morton Carpets Flexible Master Budget
Prod. 1 Prod. 2 Prod. 3 Prod. 4 Total
Units made 295,000 345,000 675,000 950,000
Units per batch 500 2,500 1,500 5,000
No. of batches 590 138 450 190
Cost per unit 5.40 3.20 4.25 1.45
Cost per batch 325.00 680.00 400.00 135.00
Unit-related costs 1,593,000 1104,000 2,868,750 1,337,500 6,943,250
Batch-related costs 191,750 93,840 180,000 25,650 491,240
Prod.-sustaining costs 125,000 168,000 256,000 355,000 904,000
Facility costs 1,450,000
Total cost center costs 9,788,490
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Flexible Budget Cost Analysis
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What did we infer from the flexible budget
slides?

• Cost standards are the same as in the case of the
  fixed budget. Why?
• Difference volume levels are adjusted to reflect
  achieved level of activity (e.g. Product 2 was
  345,000 and std. batch size of 2,500 or 345/2.5
  138 batches).
• Using std. unit cost of 3.20 and std. batch cost
  of 680, unit-related and batch-related costs for
  Prod. 2 should have been 1,104,000 (345,000 x
  3.20) and 93,840 (680 x 138).
• Planned variance reflect cost adjustment needed
  to show the differences in production volume
  between master budget and flexible budget.
• Negative variance means a cost reduction due to
  lower volume and a positive variance means a cost
  increase because of a higher volume.
• Flexible budget variances are the focus of cost
  control in a cost center.

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Cost/Expense center variances A few pointers

• Dont rush to conclusions based on positive or
  negative variances.
• Find the cause behind the variances.
• Decompose the flexible budget variances for
  unit-related costs into price and quantity
  components.
• Since analysis of variances for batch-related,
  product-sustaining, and facility-sustaining costs
  is not formalized and proceeds on an ad hoc
  basis,
• Use your common sense and rationale as a neutral
  evaluator.

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Profit Centers

• Managers of profit centers control both the
  revenues and costs of the product or service they
  deliver.
• It is like an independent business except it is
  part of a larger organization (e.g. departmental
  stores of larger chains Wal Mart, restaurants,
  corporate hotels such as Hilton, Holiday Inn).
• The store manager would have responsibility for
  pricing, product selection, and promotion.

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Profit Centers (continued)

• Cost for these units vary depending on ability to
  control labor, waste, and hours.
• Revenues also will vary depending on the units
  service level, location, etc.
• In other words, local discretion would affect
  revenues and costs.
• Investments and some costs (e.g. centralized
  purchasing).
• Therefore, profits represent a broader index of
  both corporate and local decisions.

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Profit Centers (continued)

• If performance is poor, it may reflect poor
  conditions that no one in the organization could
  control as well as poor local conditions.
• For this reason, organizations should not
  evaluate performance only based on costs and
  profits, but
• Perform detailed evaluations that include
  quality, material use, labor use, and service
  measures that the local unit can control.

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Investment Centers

• Responsibility centers whose managers and
  employees control revenues, costs, and the level
  of investment.
• It is also like an independent business (common
  when an organization acquires another
  organization e.g. Sears financial centers).

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Administrative Centers (support centers)

• One of the most difficult to evaluate because
  neither the input nor the output is easy to
  measure (e.g. accounting services, marketing),
  and
• Linking units input and output to organizational
  objectives.But, with a little careful approach,
  the costs of such centers can be reasonably
  computed.
• Since most of these centers are treated somewhat
  like cost centers, an approach based on costs
  would be helpful.

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A simple summary of the responsibility centers
Output measured in monetary terms
Revenue Center
Input measured in monetary terms
Expense/Cost Centers
Profit Centers
Output measured in monetary terms
Output measured in monetary terms
Investment Centers
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What did we learn from these control system
illustrations?

• All responsibility centers evolve from the
  concept of controllability.
• Controllability principle states a manager should
  be assigned responsibility for the revenue,
  costs, or investment that he/she could control.
• Revenues, costs, or investments that do not fall
  under a managers control must be excluded when
  evaluating the manager or his/her center.
• Problem with this concept In most organizations,
  many revenues and costs are jointly earned or
  incurred and differentiation the controllable
  from the uncontrollable is difficult.

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An alternative to Controllability

• Some argue that performance measures should be
  chosen to influence decision-making behavior.
• For example, if market prices for raw material is
  increasing, what can a manager do?
• Perhaps, enter into long term contract for fixed
  prices for raw materials.
• If electricity consumption cost is going up, find
  out how consumption can be economized (better
  machines, lighting, reduce waste).