Responsibility Centers and

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Chapter 12 Responsibility Centers and Financial
Control
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Chapter Objectives To be able to 1. Describe
the form and nature of variance analysis and
apply its basic insights. 2. Explain why
organizations use responsibility
centers. 3. Identify the issues to consider and
basic tools to use in assessing the performance
of a responsibility center. 4. Describe the
common forms of responsibility centers. 5.
Assess the issues and problems created by
revenue and cost interactions in evaluating the
performance of an organization unit. 6. Identify
the transfer-pricing alternatives available to
organizations and the criteria for choosing a
transfer-pricing alternative. 7. Use return on
investment and economic value added as financial
control tools. 8. Identify the limitations of
financial controls.
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• Financial Control and Variance Analysis
• Purpose Monitor, assess and improve operations
• Variance analysis The set of procedures used by
  managers to help them understand the source of
  differences (variances) between actual and
  budgeted costs.
• Master budget The document that forecasts
  revenues and expenses during the next
  operating period.
• Flexible budget The forecast of the projected
  level of cost given the volume and mix of
  activities undertaken.

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Financial Control and Variance Analysis First-lev
el variances For cost items, the difference
between the actual and master budget costs for
that cost item. Second-level variances The
planning variance and flexible budget variance,
which combined are the first-level
variance. Exhibit 12-1, 12-2, 12-3,
12-4, 12-5, 12-6, 12-7, 12-8, 12-9
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Variance Analysis, structure and typical
elements Production based variance analysis -
Volume - Product mix - Use/efficiency of
materials - Use/efficiency of labor -
Use/efficiency of energy - Use/efficiency of
cost drivers - Cost prices of materials -
Hourly rates of labor - Energy prices -
Etc. Sales based variance analysis - Volume
- Product mix local
currency - Sales prices -
Rebates/discounts domestic currency -
Freight/insurance - Handling GP based
variance analysis Combination of above.
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Variance Analysis, formulas Volume variance
Flexible budget - master budget (change in
quantity x budgeted cost) Product mix
variance PrMix master budget adjusted to actual
volume level - flexible budget Volume
Flexible budget - master budget - product mix
variance Use/efficiency variance (new
quantity of resource - old quantity of resource)
x actual quantity (from flexible
budget) Price/cost variance (new price -
old price) x actual quantity (from flexible
budget) Exchange rate variance (new price
local exchange x (new exchange rate - old
exchange rate) x actual
quantity (from flexible budget)
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Decentralization versus Centralization Centraliza
tion Reserving decisionmaking power for senior
management levels. Decentralization Refers
to the authority that local-division managers
have in order to make their own decisions
without having to seek higher approval on
various business operations. Discussion of
advantages and disadvantages. Conditions
necessary for effective decentralization 1.
Employees must be given, and must accept, the
authority and responsibility to make
decisions. 2. Employees must have the training
and skills they need to accept the
decision- making responsibility. 3. The
organization must have a system in place that
guides and coordinates the activities of
decentralized decision makers.
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Controlling Operations Using Financial
Control Operations control The process of
providing feedback to employers and their
managers about the efficiency of activities
being performed. Financial control A process
used to assess an organizations financial success
by measuring and evaluating its financial
outcomes. The Liz Clairborne case as an example
of the difference between financial control and
operations control, page 519. Choosing between
Operations and Financial control, page 519.
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Responsibility Centers, page 1 of
7 Definition An organization unit for which a
manager is made responsible. A responsibility
center is like a small business, and its manager
is asked to run the small business to promote the
best interests of the larger organization. Contr
olling the activities of responsibility centers
requires measuring the nonfinancial elements of
performance, such as quality and service that
create financial results. Controllability
principle States that the manager of a
responsibility center should be assigned
responsibility only for the revenues, costs, or
investment that responsibility center
personnel control.
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Responsibility Centers, page 2 of
7 Responsibility center types (exhibit
12-15) Cost Center Responsibility centers in
which employees control costs but do not
control revenues or investment level. Revenue
Center A responsibility center in which members
control revenues but do not control either the
manufacturing or the acquisition cost of the
product or service they sell or the level of
investment made in the responsibility
center. Profit Center A responsibility center
in which managers and other employees control
both the revenues and the costs of the product
or service they deliver. Investment Center A
responsibility center in which the manager and
other employees control revenues, costs, and
the level of investment in the responsibility
center.
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• Responsibility Centers, page 3 of 7
• Cost Center
• How to perform financial control in a cost
  center
• Cost-variance analysis (master budget, flexible
  budget, use and cost-price variances)
• Establish trend measurement tools (examples
  graph plots, indexes, efficiences)
• Non-financial measures such as quality, response
  time, cycle time, ability to meet
• production schedules, ethical and
  environmental commitments etc.
• Examples from Arla Foods.

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• Responsibility Centers, page 4 of 7
• Revenue Center
• Subjects to consider when determing how to
  perform financial control in a revenue center
• Quantity sold
• Prices obtained
• Product mix
• Inventory level
• Promotional activities
• perhaps deduct traceable costs such as salaries,
  advertising cost and selling costs

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• Responsibility Centers, page 5 of 7
• Profit Center
• Subjects to consider when determining how to
  perform financial control in a profit center
• Theres a risk that financial performance
  measure may contain performance such as
• 1. Conditions that no one in the organization can
  control.
• 2. Poor corporate decisions.
• 3. Poor local conditions.
• Measures should include nonfinancial measures
  that better describe performance
• influenced by the managers assigned
  responsibility.

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• Responsibility Centers, page 6 of 7
• Investment center
• Subjects to consider when determining how to
  perform financial control in an investment
  center
• Theres a risk that the financial performance
  measure return-on-investment may contain
  performance such as
• 1. Conditions that no one in the organization can
  control.
• 2. Poor corporate decisions.
• 3. Poor local conditions.
• How to include jointly used assets such as cash,
  building and equipment?
• How to include jointly created assets, such as
  cash, building and equipment?
• What cost should be used? Historical cost, net
  book value, replacement cost or net
• realizable value?

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• Responsibility Centers, page 7 of 7
• How to determine what is considered good or bad
  numbers
• Past performance
• Comparable organizations (peer groups)
• Other measurements

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Transfer Pricing, page 1 of 4 Definition The set
of rules an organization uses to assign the
prices to products transferred between internal
responsibility centers. Four approaches to
transfer pricing (exhibit 12-21) 1. Market-based
transfer prices 2. Cost-based transfer
prices 3. Negotiated transfer prices 4. Administer
ed transfer prices Purpose To motivate the
decision maker to act in the organizations best
interests. The purpose of producing management
accounting numbers is to motivate desirable
behavior regarding managers planning, decision
making and resource allocation activities.
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Transfer Pricing, page 2 of 4 Market-Based
Transfer Prices If external markets exist for
the product or service, the market price is an
appropriate basis for internal transfer of goods
or services. In addition, if the buying division
has the option to by goods or services outside
the organization, or similarly the selling
division can sell its products or services
outside the organization, that speaks for
Market-Based Transfer Prices. If an external
clear market price does not exist using
Market-based Transfer Prices could be very
dangerous and cause wrong decisions to be made
(sub-optimization).
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• Transfer Pricing, page 3 of 4
• Cost-Based Transfer Prices
• When no market price is available, a very common
  transfer price is cost-based. The most typical
  ones are at
• Variable cost
• Variable cost a percent markup
• Full cost
• Full cost a percent markup
• One could argue that any cost-based transfer
  price other than marginal cost leads organization
  members to choose a lower than optimal level of
  transactions, causing an economic loss to the
  overall organization.
• Can marginal costs at all be computed as a
  standard pricing?
• Proper economic guidance when operations are
  capacity constrained?
• Is it more important to measure exact performance
  than to apply a fair and consistent measurement
  of performance?

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Transfer Pricing, page 4 of 4 Negotiated
Transfer Prices In the absence of market prices,
a negotiated transfer price may be chosen since
it reflects the controllability perspective
inherent in responsibility centers, since each
division is ultimately responsible for the
transfer price that it negotiates. Administered
Transfer Prices Organizations often use
administered prices when a particular transaction
occurs frequently. Is typically set as market
price less x or full cost plus x.
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Criticism to Financial Control Financial control
may be an ineffective control scorecard for three
reasons 1. Focus on measures that do not
measure the organizations other important
attributes, such as product quality, the speed
at which the organizations develops and makes
products, customer service or the ability to
provide a work environment that motivates
employees. 2. Measures the financial effect of
the overall level of performance achieved on the
critical success factors and it ignores the
performance achieved on the individual critical
succes factors. The argument is that effective
control begins with measuring and managing the
elements of processes that create financial
returns, rather than measuring the financial
returns themselves. 3. Is usually oriented
towards short-term profit performance.