Responsibility Centers and Financial Control

1
Responsibility Centers and Financial Control

• Chapter 12

2
Introduction

• Georgia Tech University developed and maintained
  athletic programs to generate revenue, to attract
  top students, and to support alumni fund raising.

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Introduction

• The early 1990s saw the costs of athletic
  programs at many universities spiraling out of
  control.
• The tightening cost environment created a
  situation of desperation that called for the
  development and implementation of a system of
  financial control for varsity sports.

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Learning Objectives

• Describe the form and nature of variance analysis
  and apply its basic insights.
• Show why organizations use responsibility
  centers.
• Recognize the common forms of responsibility
  centers.
• Identify the issues to consider and basic tools
  to use in assessing the performance of a
  responsibility center.

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Learning Objectives

• Assess the issues and problems created by revenue
  and cost interactions in evaluating the
  performance of an organization unit.
• Identify the transfer-pricing alternatives
  available to organizations and the criteria for
  choosing a transfer pricing alternative.
• Use return on investment and economic value added
  as financial control tools.
• Identify the limitations of financial controls.

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Learning Objective 1

• Describe the form and nature of variance
  analysis and apply its basic insights.

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Variances

• What are variances?
• Variances are differences between actual and
  estimated costs.
• Variance analysis is a necessary step to
  understand why a difference occurred.

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First-Level Variances

• The first-level variance for a cost item is the
  difference between the actual and master budget
  costs.
• Variances are favorable if the actual costs are
  less than estimated costs.
• Variances are unfavorable if the actual costs
  exceeds estimated costs.

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First-Level Variances
Canning Cellular Services (000)
Master Actual Budget
Costs Difference Direct Material Welcome
Package 25,000 29,700 4,700 Direct Labor
Sales Staff 12,500 14,850 2,350
Technical Staff 10,000 10,890
890 Support Cost Data Processing
3,000 3,960 960 System
Activation 45,000 42,900 2,100 Total
Customer-Related Costs 95,500 102,300 6,800
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Decomposing Variances

• What are flexible budgets?
• Flexible budgets recast cost targets in the
  planned or master budget to reflect the actual
  level of production.
• This allows comparisons of actual results to
  targets based on the achieved level of production.

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Decomposing Variances

• What are planning variances?
• They reflect the effect of the volume change
  between the master budget and actual activity
  level achieved.
• What are flexible budget variances?
• They show the differences between the flexible
  budget and the actual results.

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Decomposing Variances

Master Budget Flexible Budget Planning
Variance
Flexible Budget Actual Results Flexible
Budget Variance
Planning variances and flexible budget variances
are called secondary variances.
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Decomposing Variances

• What is the direct material efficiency or usage
  variance?
• It is actual quantity used at target or standard
  price less the flexible budget allowance at the
  planned or target price.
• Usage Variance (AQ SQ) SP
• What is the direct material price variance?
• Price Variance (AP SP) AQ

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Decomposing Variances

• What is the efficiency or usage variance for
  direct labor costs?
• Efficiency Variance (AH SH) SR
• What is the rate variance for direct labor costs?
• Rate Variance (AR SR) AH
• Support costs can also be analyzed in detail.

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Decomposing Variances

• Support costs can reflect flexible or
  capacity-related costs.
• The quantity of capacity-related costs may not
  change from period to period, but the spending on
  them may fluctuate.
• What are flexible support costs?
• They reflect operations that are proportional to
  the volume of activity.

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Decomposing Variances
Canning Cellular Services (000)
Master Planning
Flexible Budget Variance
Budget Direct Material Welcome
Package 25,000 2,500 27,500 Direct
Labor Sales Staff 12,500 1,250
13,750 Technical Staff 10,000 1,000
11,000 Support Cost Data Processing
3,000 300 3,300 System
Activation 45,000 4,500 49,500 Total
Customer-Related Costs 95,500 9,550 105,050
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Decomposing Variances
Canning Cellular Services (000)
Flexible
Actual Budget Variance
Results Direct Material Welcome Package
2,200 29,700 Direct Labor Sales
Staff 1,100 14,850
Technical Staff 110
10,890 Support Cost Data Processing
660 3,960 System
Activation 6,600 42,900 Total
Customer-Related Costs 2,750 102,300
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Decomposing Variances

• The following information relates to Canning
  Cellular Service
• The actual number of new customers were 1,100,000.

Direct Materials SQ 1 AQ 1 SP 25 AP 27
Direct Labor Sales Staff SH .50 AH .45 SR 25
AR 30
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Decomposing Variances
Direct Labor Technical Staff SH .25 AH .22 SR
40 AR 45
Support Cost Data Processing SH .20 AH .24 SR
15 AR 15
Support Cost System Activation SH .15 AH
.12 SR 300 AR 325
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Decomposing Variances

• Materials efficiency variance 0
• Materials price variance
  (25 SP 27 AP) 1,100,000
  2,200,000 U
• Flexible budget variance 2,200,000 U
• Sales staff efficiency variance
  (550,000 SH 495,000 AH) 25
  1,375,000 F

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Decomposing Variances

• Sales staff rate variance
  (25 SR 30 AR) 495,000
  2,475,000 U
• Flexible budget variance 1,100,000 U
• Technical staff efficiency variance
  (275,000 SH 242,000 AH ) 40
  1,320,000 F

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Decomposing Variances

• Technical staff rate variance
  (40 SR 4 AR) 242,000
  1,210,000 U
• Flexible budget variance 110,000 F
  
• Support cost data processing efficiency variance
  (220,000 SH 264,000 AH) 15 660,000 U
• Rate variance 0
• Flexible budget variance 660,000 U

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Decomposing Variances

• Support cost system activation efficiency
  variance
  (165,000 SH 132,000 AH) 300
  9,900,000 F
• Support cost system activation rate variance
  (300 SR 325 AR) 132,000
  3,300,000 U
• Flexible budget variance 6,600,000 F

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Decomposing Variances
Master Budget
Flexible Budget
Actual Results
Planning Variance
Flexible Budget Variance
Total Variance
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Decomposing Variances
Actual Quantity Standard Price
Standard Quantity Standard Price
Actual Quantity Actual Price
Usage Variance
Price Variance

Flexible Budget Variance
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Decomposing Variances
First Level Variances Difference between the
actual and master budget costs
Second Level Variances Planning
variances Flexible budget variances
Third Level Variances Use and price variances
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Learning Objective 2

• Show why organizations use responsibility
  centers.

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Decentralization

• What are centralized organizations?
• Organizations which reserve most of the
  decision-making power for senior executives.
• Centralization works effectively in organizations
  with stable environments.

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Decentralization

• What are decentralized organizations?
• Organizations which delegate a good deal of the
  decision-making authority to lower-level
  managers.
• Decentralized organizations are effective in
  environments requiring quick responses to change.

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Decentralization

• Three conditions are necessary for effective
  decentralization
• Employees must be given, and accept, the
  authority and responsibility to make decisions.

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Decentralization

• Employees must have the training and skills they
  need to accept the decision making
  responsibility.
• The organization must have a system in place that
  guides and coordinates the activities of
  decentralized decision makers.

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Controlling Operations

• The major purpose of decentralization is to
  give decision makers the responsibility to make
  operating decisions.
• This creates a need for operations control.
• What is the focus of operations control?
• It focuses on finding the best operating
  decisions.

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Controlling Operations

• What is the focus of financial control?
• It focuses on an overall assessment of how well
  operations control is working to improve
  financial performance.

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Learning Objective 3

• Recognize the common forms of responsibility
  centers.

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Responsibility Centers

• What is a responsibility center?
• It is an organization unit for which a manager is
  made responsible.
• The centers manager and supervisor establish
  specific and measurable goals for the
  responsibility center.
• The goals should promote the long-term interest
  of the organization.

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Responsibility Centers

• Responsibility centers are classified into four
  types
• Cost centers
• Revenue centers
• Profit centers
• Investment centers

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Responsibility Centers

• What is a cost center?
• It is a responsibility center whose employees
  control costs but do not control its revenues or
  investment level.

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Responsibility Centers

• What is a revenue center?
• It is a responsibility center whose members
  control revenues but do not control the cost of
  the product or service they sell or the level of
  investment in the responsibility center.

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Responsibility Centers

• What is a profit center?
• It is a responsibility center whose manager and
  other employees control both the revenues and the
  costs of the product or service they sell or
  deliver.

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Responsibility Centers

• What is an investment center?
• It is a responsibility center whose manager and
  other employees control the revenues, costs, and
  the level of investment in the responsibility
  center.

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Learning Objective 4

• Identify the issues to consider and basic tools
  to use in assessing the performance of a
  responsibility center.

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Evaluating Responsibility Centers

• Underlying the accounting classifications of
  responsibility centers is the concept of
  controllability.
• The controllability principle asserts that people
  should only be held accountable for results
  that they can control.
• It is often difficult to apply the
  controllability principle.

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Evaluating Responsibility Centers

• What are some problems associated with
  controllability?
• jointly earned revenues and/or jointly incurred
  costs
• intricate, and often arbitrary, accounting
  procedures

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Learning Objective 5

• Assess the issues and problems created by
  revenue and cost interactions in evaluating the
  performance of an organization unit.

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Using Segment Margin Reports

• What is a segment margin?
• It is the level of controllable profit reported
  by an organizational unit or product line.

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Using Segment Margin Reports
New Car Sales
Used Car Sales
Total
Revenue 950,000 1,250,000 2,200,000 Variabl
e Costs 750,000 950,000
1,700,000 Contribution Margin 200,000
300,000 500,000 Other Costs 75,000
60,000 135,000 Segment Margin 125,000
240,000 365,000 Allocated Costs
70,000 80,000 150,000 Income
55,000 160,000 215,000 Unallocated
Costs 300,000 Organization
Profit (85,000)
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Using Segment Margin Reports

• What type of problem can occur when organizations
  evaluate responsibility centers as profit
  centers?
• identifying responsibility for the control of
  sales and costs

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Using Segment Margin Reports

• Organizations use two different approaches to
  evaluate segment margin numbers
• Past performance
• Is performance this period reasonable, given past
  experience?
• Comparable organizations
• How does performance compare to similar
  organizations?

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Using Segment Margin Reports

• What are some limitations of segment margin
  reporting?
• Margins can be highly aggregated summaries.
• Some segment reports contain arbitrary, or soft,
  numbers.
• Revenue figures often reflect assumptions and
  allocations that can be misleading.

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Using Segment Margin Reports

• Because of these limitations, interpreting
  segment margins should be done carefully.
• Other critical success factors should be used as
  well to assess performance.

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Learning Objective 6

• Identify the transfer-pricing alternatives
  available to organizations and the criteria for
  choosing a transfer pricing alternative.

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Transfer Pricing

• What is transfer pricing?
• It is a set of tools and methods used to
  attribute revenues earned by the organization to
  organization sub-units.

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Transfer Pricing

• Transfer pricing can be very arbitrary,
  especially if there is a high degree of
  interaction among the responsibility centers.

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Transfer Pricing Interrelationships
New Car Preparation
Service Department
Repairs
Used Car Department
New Car Department
Used Cars
Used Cars
Used Cars
Leasing Department
New Car Preparation
Body Shop Department
Repairs
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Approaches to Transfer Pricing

• There are four approaches to transfer pricing
• Market-Based
• Cost-Based
• Negotiated
• Administered

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Approaches to Transfer Pricing
Market-Based Transfer Pricing If a good external
market exists for the transferred product or
service, then market prices are the
most appropriate basis for pricing. Unfortunately,
these markets with well-defined prices seldom
exist.
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Approaches to Transfer Pricing
Cost-BasedTransfer Prices Variable cost plus a
markup Full cost Full cost plus a markup
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Approaches to Transfer Pricing

• What are some concerns about cost-based transfer
  prices?
• Cost-based transfer prices do not provide the
  appropriate economic guidance when operations are
  capacity constrained.
• They do not focus on the intent of the system,
  which is to allow calculation of unit incomes.

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Approaches to Transfer Pricing

• Economists argue that only marginal cost transfer
  prices are optimal.
• If the transfer price is higher than the marginal
  cost
• the supplying unit wants to sell more than the
  optimal quantity, and
• the purchasing unit wants to buy fewer than the
  optimal quantity.

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Approaches to Transfer Pricing
NegotiatedTransfer Prices Supplying and
receiving responsibility centers negotiate
prices. Prices reflect both negotiating
skills and economic considerations. Optimal
transfer price is the the net realizable value of
the last unit supplied for all units supplied.
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Approaches to Transfer Pricing
NegotiatedTransfer Prices Reflect the
accountability and controllability principles
underlying responsibility centers Can easily lead
to decisions that do not provide the greatest
economic benefits
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Approaches to Transfer Pricing
AdministeredTransfer Prices Prices set by a
rule, policy, or an arbitrator Easy to
administer Arbitrary Tend to violate the spirit
of the responsibility approach
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Learning Objective 7

• Use return on investment and economic value
  added as financial control tools.

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Efficiency and Productivity Elements of ROI
ROI Operating Income Investment
ROI Operating Income Sales
Sales Investment
ROI Return on Sales Asset Turnover
Efficiency Productivity
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Efficiency and Productivity Elements of ROI

• What is efficiency?
• It is a measure of an organizations ability to
  control costs.

Operations Efficiency Standard Cost
Actual Cost
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Efficiency and Productivity Elements of ROI

• What is productivity?
• It is a ratio of output to input.
• In financial control, this is the ratio of sales
  to investment.

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Assessing Return on Investment

• Analyze trends.
• Compare to competitors.
• Decompose and compare to competitors.
• Look for signals suggesting where there might be
  problems.

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Using Economic Value Added

• What is economic value added?
• It is an investment criterion, previously called
  residual income.

Economic Value Added Income Cost of Capital
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Using Economic Value Added

• EVA evaluates income relative to the level of
  investment required to earn that income.
• It motivates managers to do what they think is
  necessary to make economic value added as large
  as possible.

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Learning Objective 8

• Identify the limitations of financial
  controls.

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The Efficacy of Financial Control

• What are some criticisms of financial control?
• Information is delayed.
• Information is highly aggregated.
• Its measures are narrow and do not evaluate how
  well the organization is doing in meeting
  stakeholders requirements.
• It is too focused on short-term results.

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The Efficacy of Financial Control

• How should we interpret these facets of financial
  control?
• Financial control is an important tool in the
  process of control.
• Used properly, it provides crucial help in
  assessing the organizations long-term viability
  and identifying processes that need improvement.

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Conclusion

• Georgia Tech implemented a Responsibility
  Approach Center (RAC), which focuses on computing
  a cost per sport.
• The analysis revealed that all sports, with the
  exception of basketball, were a net drain on the
  Universitys resources.

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End of Chapter 12