Chapter 3

Responsibility Centers

Concept of Responsibility Centers Revenue Centers Engineered Expenses Centers Discretionary Expenses Centers Profit Centers Investment Centers Concept of Responsibility Centers Responsibility center is unit of organization that is headed by a manager having direct responsibility for its performance. The responsibility area may be classified on the basis of department, product line, territories or any other type of identifiable unit. An organization is composed of a number of financial responsibility centres. These responsibility centres are created by management based on the needs of the business enterprise. Responsibilities centres may be define as an organizational unit which is headed by a responsible person namely a manager. He is responsible for the activities of the unit. The responsibility centres is responsible for performing some function which is its output. In performing these functions, it uses resources or inputs. The costs assigned to a responsibility centre are intended to measure the input that it consumes in a specific period of time, such as a week or a month.

Types of Responsibility Centers

1. Revenue Centers 2. Expenses Centers/ Cost Centers Engineered Expenses Center Discretionary Expenses Center Administration & Support Center Research & development Centers Marketing Centers 3. Profit Centers 4. Investment Centers

Revenue Centers Revenue is a monetary measure of output. Where the output of responsibility centre is measured in terms of money, we have what is known as revenue centres. According to Anthony, in a revenue centre, outputs are measured in monetary terms, but no formal attempt is made to relate inputs (i.e. expense or cost) to outputs. Examples of revenue centres are marketing organization where no responsibility for profit exists. Orders booked and sales are compared with the budget to measures their performance. The primary yard stick for judging the efficency of revenue centres is revenue earned vis a vis the budget. However, the head of the revenue centre is held responsible for expenses incurred by his responsibility centre. Generally, revenue centre managers do not have responsibility for estabilishing selling prices. Thus, in a revenue centre, there is no relationship between inputs and outputs. Following figures shows the features of revenue centres.

Revenue Centers Input Not Related to Output

Inputs

Outputs

Rupees only for cost directly incurred

PROCESS

Rupee for revenue

Cost Centers A cost center is unit of organization in which the manager held responsible for the cost incurred in that segment. This unit is not responsible for revenues. The plans of this center are in the form of cost estimates, while the performance is evaluated with the help of cost variance, that is, the difference between budgeted cost and actual cost. The managers of cost centers have control over some or all costs but not on the revenue. Since all costs are not controllable, the cost center manager is responsible only for those costs that are controllable by him and his subordinate.

Engineered Expenses Center Engineered expense center is a unit where inputs are measured in monetary terms and outputs are measured in physical terms. Engineered expenses centers are usually found in manufacturing, warehousing, distribution and trucking. Engineered expense centers do not just measures the cost but also responsible for the quality and volume of output. Therefore the type and level of production and quality standards are set so that cost reduction is not achived by compromising with the quality. Example Manufacturing Unit Engineered Expense Centers Optimal relationship can be established

Inputs

Outputs

Rupees

PROCESS

Physical

Discretionary Expenses Center Discretionary expenses center includes administration and support services, R&D and most marketing activities. The operating profit of these centers cannot be measured in monetary terms. Discretionary expenses reflect the management policies regarding certain expenses. Some examples of management policies that deals with under discretionary expenses are:

Marketing efforts initiated to face competition Services to be provided to customers Expenditure on R&D Financial planning and control mechanisms

Discretionary Expense Centers Optimal relationship cannot be established

Inputs

Outputs

Rupees

PROCESS

Physical

Budgeting Aspects of Engineering and Discretionary expenses center In the case of engineered expenses centres, operating budgets are prepared based on management decision regarding the cost of performing task efficiently for the future period. In other words, management decision whether the proposed operating budget represents the cost of performing task efficiently for the coming period. The size of the task is not much concern to management as the same is namely determined by the actions of the other responsibility centres. For instant production is depend upon the marketing department capacity to sell. However, while budgeting for a discretionary expenses centre one of the main problem confronting the management the management to take a decision on the magnitude of the task. This become the principal task of the management. Management task is of two types (1) Continuing (2) Special. Where tasks have a tendency to reoccur from year to year they are known as Continuing task these task continue form year to year. Instance of such tasks are prepration of annual tax returns, prepration of profit and loss account & balance sheet and other financial statements during year end etc. On the contrary , special tasks may be describe as one time project which arises once and remains till the same are completed. For instant, developing and installing a ERP in the firm. While preparing a budget for a discretionary expenses centre, management by objectives technique is generally used,. To quote Anthony, MBO is a formal process in which a budgeted proposes to accomplish specific tasks and states a means for measuring whether these tasks have been accomplish. In so far budget for Discretionary expenses centres are concerned, two methods are used. They are:

(i) Incremental Budgeting:In case if incremental budgeting the expenses incurred during a particular period in a discretionary expenses centre is taken as given. In other words, the present level of expenses is assumed as the starting point. Proper adjustment are made to the expenses in order to arrive at budgeted amounts. The adjustment are carried out for special tasks, for expenses changes in the work load of continuing tasks, for inflation, for cost of compaaraable work in similar units. Generally, organizations in India have been found to use this method. The merits of this method are simplicity and saving in time. The shortcoming are that during business downturns, change in management etc, such expenses are substantially reduce without making a bad impact on the business. Secondly, this has a tendency to increase overheads expenses from period to period. Managers of DEC are interested in providing additional services and as a result they have a tendency to make request for extra resources during budgeting, which is generally sanctioned. Available evidence suggest that the same is not necessary (ii) Zero Base Budgeting:Using Zero base review involves through analysis. Each discretionary expenses centre is thoroughly analyzed. The management prepares a schedule that would cover all discretionary expenses over a period of five years or so. As a result off this exercise, a new base is derived. The Zero base review does not take things for given. There is no starting point. The review which is extremely extensive in nature is builds up from scratch the resources that an activity needs. It raises certain fundamental questions and challenges established norms. The questions raised are: (i) (ii) (iii) (iv) It is necessary to perform the function at all? Does the same add the value from the view point of end uses (Customer). What should be the level of quality? Are we doing to much? Is it desirable to perform the function in this manner? What should its cost be?

Intra firm comparisons, interfirm comparisons, and bench marking are also used as a part of approach. Cost and output measures of the expenses centre are compared with averages of similar units within the firm. This is known as intra-firm comparison,. Similar comparisons may be made with data which is published by trade associations and other outside organizations. Such an exercise is called interfirm comparisons. When a comparison is made with information obtained by visits to a firm in which the performance is believed to be outstanding, it goes by the name of benchmarking. Zero base review is not a rose without thorns. It has its drawbacks also Firstly, such reviews are difficult. Responsibility centre heads consider such review as unnecessary evil. They make concerted efforts to justify their present expenditure and of then do their best to foil the entire exercise. The people also speared rumors and create doubts in the minds of the people regarding the efficacy of the exercise. Secondly, it takes a lot time and energy and can be nightmare for responsibility centre heads whose operations are being reviewed.

Performance Aspects of Discretionary Expenses Center In case of an Engineered Expenses Centre the financial performance report is used for evaluating the managers efficiency. Managers who spend in accordance with the budget amount or less are considered efficient. In contrast, the main job of the discretionary centre head is to accomplish the planned output. Accordingly, actual expenses incurred by him are viewed in relation to the desired output. Expenses incurred may be lower then the budget and this is an indication that the planned work has not been done. In case, the spending is according to the budget the situation is looked upon with satisfaction. Where the amount expended is higher than the budget, it causes concern. The manager of a Discretionary Expenses Centre plays a vital role in expenditure control. The system should ensure that his approval is obtained before there is a budget overrun. However, in reality a nominal percentage of overrun is allowed without prior approval.

Administration & Support Center Administrative center includes senior corporate management and business unit management along with the manager of the supporting staff unit. Support units are units that provides services to other responsibility centers. It is very difficult to exercise control over these centers because of the following reasons:

Difficulty in measuring Output: Principal output of Administrative & Support Center is advice or service functions that are virtually impossible to quantify. Since output cannot be measured, it is not possible to set cost standards against which to measure financial performance. Lack of Goal Congruence: Managers of administrative staff strives for functional excellence. Superficially, this desire would seem to be congruent with company goals, in fact, much depends how one defines excellence. A striving for excellence can lead to empire building or to safeguarding ones position without regards to the welfare of the company.
Budget Preparation The proposed budget for an administrative or support center usually consist of a list of expenses items, with the proposed budget being compared with the current year actual expenses. Some companies request a more elaborated presentation, which may include some or all of the following components:

A section covering basic costs of the center for which no general management decision are required. A section covering the discretionary activities of the center A Section fully explaining all proposed increase in the budget.

Research & development Centers Research and Development constitutes a very important function in modern organizations. With the liberalization of the Indian economy and globalization, a number of opportunities and challenges have been thrown up. This has increased the importance of research and development. Budgeting in Research and Development Center Research and Development being a discretionary expense, it is difficult to budget for the same on a scientific basis. A number of factors are generally considered while budgeting for such expenses:

Firms normal spending level Competitors spending Firms strategic plan Significant break through during previous year

A specific percentage of average annual revenue is used for arriving at the budget amount. The reason underlying this is simple. The size of the R&D centers should not vary with short term fluctuations in revenue. Within the overall ceiling established for research and development expenses, the research programme consist of a number of project plus an additional amount for unplanned work. There is a committee within the organization for reviewing research work. The task of the committee is to take macro decision in so far as projects are concerned. The decision concern the magnitude of the projects namely projects in which expenditure is to be reduced, new projects, projects that are to be discontinued, and projects in which expansion of work should take place. Having decided and implemented the long range research programme, the next task is to prepare the annual research and development budget. The budget should confirm to the firms strategic plan. Management should

raise the searching question during this process. The questions should focuse on best use of resources expected to be utilized during the budget period in the light of development which have take place so far. The expected expenses during the budget period are sub divided into calendar periods. The benefits which arise from annual budgeting are two in number. Firstly, costs are not allowed to exceed budgeting limit, approvals of appropriate level of management is required where expenditure is expected to be more then the amount budgeted. Secondly, it provides an opportunity to the management to review the research and development program.

Problem of Control in Research & Development Centers

1.

Lack of goal congruence: The head of research and development centers generally feels inclined to have an excellent department which may beyond the companies means. It is also found that the personnel engagement in research and development occasionally do not have interest in the business or adequate knowledge of the business in order to provide proper direction to research.

2. Difficulty in Relating Results to Inputs: The results of research and development activates are difficult to measure quantitatively. In contrast to administrative activates, R&D. usually has at least a semi tangible output in the form of patents, new products, or new processes; but the relationship of output to input is difficult to appraise on an annual basis because the completed product of an R&D group may involve several years of effort. Thus, inputs as stated in an annual budget may be unrelated to ouputs. Further more even when such a relationship can be established it may not be possible to reliably estimate the value of the output. And even when such an evaluation can be made, the technical nature of the value of the output. And even when such an evaluation can be made, the technical nature of the R&D function may defeat managements attempt to measure efficiency. A brilliant effort may against an insuperable obstacle, whereas a mediocre effort may, by luck, result in a bonanza. 3. Several year for results: As research years take several years to bear fruits, it is difficult to control research and development in effective manner on an annual basis. It takes sevral years to build up a proper research and development center. The main element of expenditure is manpower cost and getting highly skilled personnel is generally difficult.

Performance Measurement in R&D Centers The measurement of performance is done by preparing and presenting financial reports to appropriate levels of management. These reports are prepared on a monthly or quarterly basis in respect of all responsibility centers and projects and show actual expenditure incurred against budgeted amount. Performance report presented to the management may be of two types. In first type actual expenses incurred in each responsibility center is compared with the budgeted amounts. This enables the executives in the R&D department to plan their expenses and ensure that commitments made regarding expenses are being met. The second type involve the comparison of amount approved for each project which is in progress with the current forecasted figure of total cost. This enable the management to ascertain whether it is worthwhile making changes in project which have been approved. In this context it should be noted that this report is presented in a periodic manner to the head of R&D department. Although these reports are of value to the management, judgment about the effectiveness of research is generally made based partly on these financial reports and mainly on the basis of discussions.

Profit Centers When financial performance in a responsibility center is measured in terms of profit, which is the difference between the revenue and expenses, the responsibility center is called a profit center. A profit center is the unit of organization to which both revenue and costs are assigned so that the profit of the unit can be measures. A profit center can be established only when the unit costs and revenue can be separately attributed. A profit center works efficiently when the manager can make decision about the selling price and the level of output to be sold at those prices. The performance of profit center is measured in absolute term i.e. Profit Profit Centers Input are Related to Output

Inputs

Outputs

Rupees Cost

PROCESS

Rupee Profit

Investment Centre An investment centre is a responsibility centre in which the manager is held responsible for the use of assets as well as for revenue & expenses. It is therefore the ultimate extension of the responsibility idea. The manager is expected to earn a satisfactory return on capital employed in the responsibility centre. Measurement of the investment base or capital employed gives rise to many difficult problems and the idea of the investment centre being new, there is considerable disagreement as to best solution of these problems. Investment Centers Input are Related to Capital Employed

Inputs

Outputs

Rupees Cost

Capital Employed

Rupee Profit