Responsibility Centres

A responsibility center is an operational unit or entity within an organization, that is

responsible for all the activities and tasks structured for that unit. These centers have their
own goal, staffs, objectives, policies and procedures, and financial reports.

A responsibility center is any part of an organization. It may be a product line, a

geographical area, or any other meaningful unit. There are four common types of
responsibility centres.

1. Cost Centers: Responsible only for the incurrence of costs (any revenue it may earn
is immaterial). A cost center is an organizational sub unit, such as a department or
division, whose manager is held accountable for the costs incurred in the subunit.
Example, janitor department.
2. Revenue Centers: Responsible only for generating revenues and is not measured by
its expenses. This segment is primarily responsible for attaining sales revenue. The
performance would be evaluated by comparing the actual revenue attained with the
budgeted revenue. Example, sales department or the salesperson.
 Responsibility Centres
1. Profit Centers: Responsible for both the incurrence of costs and generating
revenue. Here the manager would have all of the responsibility to make
decisions that would affect both the price and the revenue. Example, a product
line for which the product manager will be responsible.
2. Investment Centers: Responsible not only for the incurrence of costs and
generating revenues, but also for providing a return on an investment. This
center looks into returns on the funds invested in the group’s operations during
its time.
 Responsibility Centres- Advantages
1. Assignment of Role and Responsibility: When there is a responsibility
attached to each segment, each individual is aligned and directed towards a
purpose with the responsibility in line with their roles.
2. Improves Performance: The idea of assigning tasks and responsibilities to a
particular person would stand to act as a motivational factor.
3. Delegation and Control: The assignment of responsibility center with roles
assigned to various segments helps the organization bring about and achieve the
purpose of delegation.
4. Helps in Decision Making: Responsibility centers help the management in
decision making as the information collected from various centers helps them
plan their future actions.
5. Helps in Cost Control: Having segment-wise breakup responsibility centers
help the top management in having to assign different budgets for the various
centers.
 Evaluating Manager / Department
Whenever an evaluation of a manager is made, it is important that the manager be
evaluated only on things that they are able to control.

Similarly, departments should not be evaluated on things that they cannot control.

A performance of each responsibility centre is summarized periodically on a

performance report. It shows the budgeted and actual amounts, and the variance
between these amounts and the responsibility centre involved.
 Allocation of Common Costs
The method of allocation should:
• Provide accurate departmental and product costs
• Motivate managers to make their best effort
• Provide a fair evaluation of managers´ performance
• Provide incentives for managers to make decisions that are consistent with the
company’s goals,
• Justify costs for transfer prices or cost based contracts

A collection of cost to be assigned is called a cost pool. The process of assigning the
costs in the cost pool to the cost object is called cost allocation or cost distribution.

An allocation base is a measure of activity, physical or economic characteristic, that

is associated with the responsibility centre
 Considerations for Cost Allocation
• Cause and effect – activities that cause resources to be consumed are identified,
and cost allocations are based upon each responsibility center’s usage of the
resources.
• Benefits received – based upon the benefit received by each responsibility
center.
• Fairness or equity – allocation should be “reasonable” or “fair”.
• Ability to bear – costs are allocated based upon the ability of the responsibility
center to bear the cost.
 Segment reporting
It provides management with information or a division or department’s revenue,
expense and profitability. Segmented reporting refers to the preparation of accounting
reports by segment and for the organization as a whole. A segment is any part or
activity of an organization about which a manager seeks cost, revenue, or profit data.

Contribution is the difference between selling price of a unit and all variable
expenses (both production and non-production variable expenses).

Key Features of Segmented Reporting

1. Contribution format.
2. Controllable versus uncontrollable expenses.
3. Segmented income statement.
 The Contribution Income Statement
Revenues
- Variable Manufacturing Costs
= Manufacturing Contribution Margin
- Variable Nonmanufacturing Costs
= Contribution Margin
- Controllable Fixed Costs
= Controllable Margin
- Noncontrollable, Traceable Fixed Costs
= Segment Performance
- Noncontrollable, Untraceable Common Costs
= Operating Income
 The Contribution Income Statement
• Manufacturing contribution margin: The amount of money that is available to
cover nonmanufacturing variable costs, all fixed costs, and then flow to profit.
• Contribution Margin: The amount of money that is available to cover fixed
costs and then profit.
• Controllable Margin: Also called short-term segment manager performance.
The controllable margin is a useful measure of a manager’s short-term
performance.
• Segment Margin: Measures the performance of each business unit.
• Net Income
 Company
as a whole Division 1 Division 2
Net Revenues $10,000 $3,000 $7,000
Variable Manufacturing Costs 3,900 900 3,000
Manufacturing Contribution Margin (Level 1) 6,100 2,100 4,000
Variable Nonmanufacturing Costs (selling, admin.) 600 100 500
Contribution Margin (Level 2) 5,500 2,000 3,500
Controllable Fixed Costs 1,250 500 750
Controllable Margin or Short-term Segment
Manager Performance (Level 3) 4,250 1,500 2,750
Non-controllable, Traceable Fixed Costs 2,000 600 1,400
Contribution by Strategic Business
Unit or Segment Performance
(Segment Margin) (Level 4) 2,250 $ 900 $1,350
Non-controllable, Untraceable, Common Costs 1,000
 Activity-Based Responsibility Accounting
Traditional responsibility-accounting systems tend to focus on the financial
performance measures of cost, revenue, and profit for subunits of the organization.

Activity-based costing systems associate costs with the activities that drive those
costs. In activity-based responsibility accounting, attention is directed not only to
costs incurred but also to the activity creating the cost.

Behavioral Effects of Responsibility Accounting

• Controllability
• Motivating Desired Behavior
• Information versus Blame
 Operational Performance Measures in Today’s
Manufacturing Environment
Raw Material & Scrap Control
• Quality
• Lead time
• Cost of scrap
• Total cost
Inventory Control
• Average value
• Average holding time
• Ratio of inventory value to sales revenue
 Operational Performance Measures in Today’s
Manufacturing Environment
Machine Performance

• Availability
• Downtime
• Maintenance records
• Setup time

Production

• Manufacturing cycle time

• Velocity
• Manufacturing cycle efficiency
 Operational Performance Measures in Today’s
Manufacturing Environment
Delivery
• % of on-time deliveries
• % of orders filled
• Delivery cycle time

Innovation and Learning

• Percentage of sales from new products
• Cost savings from process improvements
 Balanced Scorecard
The balanced scorecard is a balanced approach to the area of performance evaluation.
Employees are evaluated on a series of financial and nonfinancial measures in a variety of
areas.

Effective management requires a balanced perspective on performance measurement, a

viewpoint that some call the balanced scorecard perspective. Key to understanding the balanced
scorecard is the distinction between lead and lag indicators of performance.

Lead indicators guide management to take actions now that will have positive effects on
enterprise performance later. Lag indicators are measures of the final outcomes of earlier
management decisions.

To make successful use of the balanced scorecard, the scorecard’s lead and lag measures need to
be linked to the organization’s strategy. The organization’s vision and strategy drive the
specification of both goals and metrics in the scorecard’s financial, customer, internal
operations, and learning and growth perspectives.
 The Balanced Scorecard
Financial

Vision and Internal

Customer Strategy Operations

Learning and Growth

 Delegation of Decision Making
(Decentralization)
As organizations grow, decision-making must be pushed down to lower level
managers. Organizations often decentralize into subunits to take advantage of the
specialized skills and talents of their sub-managers.

Some of the advantages of pushing decision-making down to lower level managers

are: it allows managers to respond more quickly to events, it uses the skills of those
managers, and it frees upper management to focus on long-term planning and other
strategic goals.

The challenge, for a decentralized organization, is to induce managers to behave

in a manner that achieves organizational goals, rather than focusing on the goals of
the subunit.
 Goal Congruence
Goal congruence is a situation in which people in multiple levels of an organization
share the same goal. A well thought-out organizational design causes goal
congruence and results in an organization being able to work together to accomplish
a strategy.

It is obtained when the managers of subunits throughout the organization strive to

achieve the goals set by top management. To achieve goal congruence, the behavior
of the managers throughout an organization must be directed towards top
management’s goals.
Management by Objectives (MBO)- Is a model that aims to improve the
performance of an organization by clearly defining objectives that are agreed to by
both management and employees. Management by objectives (MBO) is a process
in which a manager and an employee agree on specific performance goals and then
develop a plan to reach them.
 Return on Investment (ROI)
Return on investment is calculated by simply dividing the investment center’s net
income by the amount invested in the division. The ROI figure can be broken into
two insightful measurements, the center’s sales margin and the turnover ratio

ROI = Income
Invested Capital
Income Sales Revenue
ROI = Sales Revenue × Invested Capital

Sales
Sales Capital
Capital
Margin
Margin Turnover
Turnover
Here is an example of the return on investment calculation. Holly Company had
income of $30,000; Sales of $500,000; and the investment was $200,000.
Holly Company reports the following:
Income $ 30,000
Sales Revenue $ 500,000
Invested Capital $ 200,000

ROI = Income Sales Revenue

×
Sales Revenue Invested Capital

ROI = 6% × 2.5 = 15%

 Improving R0I
Decrease
Expenses
Increase Lower
Sales Invested
Prices Capital

Three ways to improve ROI

Several things that managers can do to improve their investment center’s ROI are;
increase their sales price, decrease their center’s expenses, or decrease the amount
invested in the subunit.
 Economic Value Added
Economic value added tells us how much shareholder wealth is being created. It is
the incremental difference in the rate of return (RoR) over a company's cost of
capital. Essentially, it is used to measure the value a company generates from funds
invested in it.

Example: If a company has a net profit of $100,000, an invested capital of $50,000,

and a weighted average cost of capital of 10%, the economic value added would be
$95,000
• To calculate the EVA measure, we take the operating income less the charge for
the investment.
• The charge for the investment is calculated by multiplying the net worth of the
division, assets minus liabilities, times the weighted-average cost of capital.
• The weighted-average cost of capital is calculated by taking the cost of debt times
the value of the debt and adding it to the cost of equity times the market value of
the equity.
• This result is then divided by the market value of debt plus the market value of
equity.
 Investment center’s after-tax operating income
– Investment charge
= Economic Value Added

( )
Investment Investment Weighted-
center’s – center’s  average
total assets current liabilities cost of capital

( ) ( )
After-tax Market Cost of Market
cost of  value  equity  value
debt of debt capital of equity
Market Market
value  value
of debt of equity
Ray's earned $100,000 on a capital base of $1 million thanks to its sales of stew pots.
Traditional accounting metrics suggest that Ray is doing a good job. His company
offers a return on capital of 10%. However, Ray's has only been operating for a year,
and the market for stew pots still carries significant uncertainty and risk. Debt
obligations plus the required return that investors demand add up to an investment
cost of capital of 13%. That means that, although Ray's is enjoying accounting
profits, the company was unable to grant 3% to its shareholders.

If Ray's capital is $100 million—including debt and shareholder equity—and the

cost of using that capital (interest on debt and the cost of underwriting the equity) is
$13 million per year, Ray will add economic value for his shareholders only when
profits are more than $13 million per year. If Ray's earns $20 million, the company's
EVA will be $7 million.
 Invested capital
Invested capital is the investment made by both shareholders and debtholders in a
company.
The calculation for invested capital under the financing approach is:

+ Amount paid for shares issued

+ Amount paid by bond holders for bonds issued
+ Other funds loaned by lenders
+ Lease obligations
- Cash and investments not needed to support operations
= Invested capital
 Invested capital
Alternatively,

+ Net working capital needed for operations

+ Fixed assets net of accumulated depreciation
+ Other assets needed for operations
= Invested capital
 Residual Income
Conceptually, residual income is net income less a charge (deduction) for common
shareholders’ opportunity cost in generating net income. It is the residual or
remaining income after considering the costs of all of a company’s capital.

A company can have positive net income but may still not be adding value for
shareholders if it does not earn more than its cost of equity capital. Residual income
models explicitly recognize the costs of all the capital used in generating income.
 Measuring Investment Center Income

Division managers should be evaluated on profit margin they control. Exclude these
costs:

• Costs traceable to the division but not controlled by the division manager.
• Common costs incurred elsewhere and allocated to the division.
Performance of division managers should be measured only on the assets that they
can control. Division performance should not be measured using shared or allocated
costs
 PRACTICE QUESTION
The following selected information is from the financial statements for the last fiscal
year.
Current assets $ 500,000
Fixed assets 250,000
Current liabilities 100,000
Long-term debt 300,000
Stockholders’ equity 350,000
Operating profit 1,000,000
Income taxes 400,000
Net income 600,000
The company has a cost of capital of 10%. Balance sheet amounts remained constant
throughout the year. The company’s residual income for last year was
 ANSWER
Economic value added can be calculated as follows:
Residual income =
Operating profit – (Assets of business unit × Required rate of return)
= $1,000,000 – ($750,000 × 10%)
= $1,000,000 – $75,000
= $925,000
 PRACTICE QUESTION
A company’s management is planning on making an investment of $800,000 to
launch a new product. In the first year, the new product is expected to generate sales
of $200,000 and a contribution margin of $175,000. Incremental fixed costs are
$50,000. The company’s expected return on investment in the first year is closest to
 ANSWER
ROI is calculated by dividing business unit profit by invested capital. The new
investment will make a profit of $125,000 ($175,000 contribution margin – $50,000
incremental fixed costs). Hence, ROI = $125,000 ÷ $800,000 = 16%.
 PRACTICE QUESTION
A company has recently implemented responsibility accounting in all 7 segments of
the company. The following information is available for Segment W for the last
quarter.
Net working capital $1,200,000
Property, plant, and equipment, net 3,175,000
Revenues 8,000,000
Cost of sales 6,350,000
General and administrative expenses 180,000
Based on the information provided, if the company treats Segment W as an
investment center, what is the return on investment for the last quarter?
 ANSWER
Return on investment is equal to the income of the business unit divided by the
assets of the business unit. Income of Segment W is $1,470,000 ($8,000,000 revenue
– $6,350,000 cost of sales – $180,000 general and administrative expenses). Assets
of Segment W equal $4,375,000 ($1,200,000 net working capital + $3,175,000
PPE). Thus, return on investment is 33.6% ($1,470,000 ÷ $4,375,000).
 PRACTICE QUESTION
Residual income is the excess of the amount of the ROI over a targeted amount equal
to an imputed interest charge on invested capital. If a manager has $19,000,000 of
invested capital ($17,200,000 of plant and equipment + $1,800,000 of working
capital), a 15% imputed interest charge equals $2,850,000. Adding $2,000,000 of
residual income to the imputed interest results in a target profit of $4,850,000. This
profit can be achieved if costs are $25,150,000 ($30,000,000 revenue – $4,850,000
profit).
 ANSWER
Return on investment is equal to the income of the business unit divided by the
assets of the business unit. Income of Segment W is $1,470,000 ($8,000,000 revenue
– $6,350,000 cost of sales – $180,000 general and administrative expenses). Assets
of Segment W equal $4,375,000 ($1,200,000 net working capital + $3,175,000
PPE). Thus, return on investment is 33.6% ($1,470,000 ÷ $4,375,000).