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Responsibility Centers

Prof Rishi Chourasia


Management Vikalp
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What is a Responsibility
Center?

The Responsibility is the unit in the organization

that has control over costs, revenues, or


investment funds.
Responsibility center is an entity, held accountable
for an activity/function under consideration, that
becomes its objective/goal
Organization can be looked upon as collection of
responsibility centers.
Each RC consumes certain amount of resources
INPUTS and produces certain results OUTPUT
Best option to assess the performance of RC starts
with establishing relationship among INPUT and
OUTPUT and then applying it scrupulously
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Responsibility
Centersfurther defined
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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The basic definition of a


responsibility center
Lowest organizational level at which

funds control functions are carried out.


Generally the same as divisions in an
operating component.

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For accounting purposes,


responsibility centers have four
classifications:

Revenue Centers

Cost Centers
Profit Centers
Investment Centers
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Responsibility Centers 1. Revenue Center Prime concern of the REVENUE CENTER


TOPLINE
e.g. Marketing center
Inputs
Output
RCs
(Money directly
(Sales Generated
TASK
spent on achieving
in money terms)
sales i.e. Mktg. Exp.)

Generate Sales

RC has no authority to decide price.


RC is charged with cost of Marketing and not with cost of
goods produced
No formal relationship possible between I & O
Performance Measure for the RC can be Revenue Budgets.
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Revenue Center
A Revenue Center is responsible for selling

an agreed amount of products or services.


It's manager is usually responsible to
maximize revenue given the selling price
(or quantity) and given the budget for
personnel and expenses.

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Revenue Center - Issues


Decision Rights
Promotion Mix
Performance Measures
Maximize total sales for a given promotion budget
Actual sales in comparison with budgeted sales
Typically used when
RC manager has thorough knowledge about market
Promotion plays significant role in generating sales
RC manager can establish optimal promotion mix
He can set optimal quantity and appropriate

rewards

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2. 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).

Cost/Expenses Center:
Engineered Expenses V/s Discretionary
Expenses
e.g. R&D Project

e.g. Manufacturing a

product
Can be established
scientifically
Cost varies with even
small fluctuations in
volume
Control is easier.
Control starts with
planning & ends with
finished task.
Financial Performance
measure suffice the
purpose of evaluation.
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Can not be established


scientifically
Costs varies with bigger
volume changes
Review of task is the only
control measure for cost
control. Control is
exercised during planning
stage itself, by way of
establishment of budget
Financial as well as non
financial Performance
measure need to be

Cost Center
Inputs
(Money spent on
production)

RCs
TASK

Output
(Physical units
Produced)

Decision Rights
Input Mix Labor, Material, Supplies

Performance Measures
Minimize total cost for a fixed output
Maximize output for a given cost budget

Typically used when


RC manager can measure output & quality of output
knows cost functions, optimal input mix
can set optimal quantity and appropriate rewards
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2. Expenses Center
2.1)Engineered Exp. Center e.g. Production
Department
Engineered expenses are those expenses which
are arrived at with reasonable reliability.e.g.
Material cost , labor cost.

Inputs
(Money spent on
production)

RCs
TASK

Output
(Physical units
Produced)

Performance Measure for the RC is std.cost: -

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Std Cost of doing actual activity = Std. cost of unit activity *


Quantum of Actual activity
One can establish relationship between I & O , hence
performance measurement is relatively easy
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2. Expenses Center
2.2) Discretionary Expenses Center -e.g. R&D,
Advt. Dept, a Movie Project
Discretionary expenses are those expenses
which can not be established with perfect accuracy

Inputs
(Money spent on
R & D)

RCs
TASK

Output
(Product
Development)

Difficult to estimate Input (hence called MANAGED


costs)
Output can not be measured in monetary terms.
Difficult to establish optimal relationship between I and
O
Performance Measure for the RC is Budgeted Input and
Actual Input.
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Control Characteristics of Discretionary Cost Center


Heavy Reliance on Budgets
For on going activity its bit easier than a new project
Budgeting technique used for controlling could be
Incremental Budgeting
Zero Base Budgeting
Difficult to control short term fluctuations, as Discretionary
costs usually remain unaffected in short term unlike
engineered costs.

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Discretionary Expenses Center - Examples


i)

Administrative and Support Centers-

Senior management units at corporate level e.g.


Legal, Planning , IT , Audit Departments

Goals may differ and hence performance

ii) Research and Development Centers

The input and output may span over


different and uneven time periods.

iii) Marketing Center -

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3. Profit Center Profit is most comprehensive measure of performance


Function/Activity having highest influence on Bottom

Line suits best for Profit Center.


Can be a Business Division or any of the functional unit
Demands highest freedom/autonomy than any other
RCs

Inputs
(Money spent for
earning profits)

RCs
TASK

Output
(Money-profit
Earned out of sales)

Relationship can be established


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Profit Center
Decision Rights
Input Mix Labor, Material, Supplies
Product Mix
Selling Price
Performance Measures
Actual Profits
Actual Profit in comparison with budgeted profits
Typically used when
RC manager has knowledge about correct
price/quantity
RC manager has knowledge to select optimal
product mix
CANDIDATES FOR PROFIT CENTER
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3. Business Unit as Profit


Center
Business Units In a Decentralized Company
Best suited as Profit Center
Marketing Center as Profit Center
Marketing Function having highest influence on
Bottom Line, e.g. Colgate, Coca-Cola, Wipro- Bath

Soaps division, Dabur-Cosmetics division etc.


When centralized control is infeasible e.g.
Foreign Marketing Center e.g. IBM, Microsoft, Honda
India

To Convert Marketing Division into Profit Center


Charge cost of production to revenue center
Grant of maximum autonomy to the unit
Delegate sufficient authority
Treat the unit as a mini company
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3. Functional Unit as Profit Center


Manufacturing Division
When Cost of production having highest impact
on Bottom Line and
When Marketing Function is relatively
insignificant
o e.g. Nirama Detergent
To convert a Production Division in to Profit Center
Credit selling price less marketing expenses to

production division

3. Service and Support Center


o e.g. Maintenance, Customer Service, Transportation,
Engineering Design Divisions

Given greater autonomy, helps them to cut cost and


make its operations more efficient
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3. Profit Center Performance Measures


Justification

Performance Measure

Revenue
Less VC of Mfg. & Marketing

1. Contribution Margin

Fixed Cost is beyond control of PC

Less Fixed Expenses

2. Direct Profit

All Expenses incurred at the behest o

Less Controllable Corporate Expenses

3. Controllable Profit
Less Other Corporate Allocations

4. Net Profit Before taxes


Less Income tax

5. Net Profit
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Some HQ expenses exclusively incurr


for given PC at HQ IT services
Common unavoidable expenses
incurred to run a company ; e.g.
All administration, financing and tax
planning activities are carried at HQ

In some cases RC do have


impact on tax liability of the company
Tax Heavens

3. Profit Center Advantages


Improves quality of decision RC Mgr are closest to the point of
decision
Improves speed of decision less intervention by HQ
HQ is relieved of day-to-day decisions making process
can
decisions

concentrate on more strategic

Provides training ground for general mgt. as RCs acts as


mini
Cos. profit consciousness with every expense made.
Enhances
promotional
the sales).

(mktg. mgr. will tend to authorize


expenditure which increases

Provides best performance indicators of Cos individual


component.
Since output is clear cut evident, it evokes competition.
Ensures better and safer delegation of authority.
Ensures better motivation and evokes commitment.
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3. Profit Center Dis-Advantages


Caliber of RC mgr. may hamper the decision.
Incase of more integrated company there may be
problems of cost sharing, transfer pricing, sharing credit
for revenue.
Divisionalisation may impose additional cost of
admn/support units.
Functional set up may not have competent of GM to manage
RC.
Functional units once cooperated may now be in
competition with
one another- (as profit of one is loss to
another).
May encourage short term motive at the expense of Cos
overall goal.
Optimization of RCs profit not necessarily mean
optimization of
companys profits.
Decentralization makes top mgt. to rely more on MC
reports
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Responsibility Centers
4. Investment Centers
Inputs
(Money spent for
Starting & running
the business)

Output
RCs
TASK

(Money/net profit
Earned on account
of investment)

Objective Make sound investment decision


It compares Business units profits with assets
employed to earn that profit i.e. efficiency of assets
employed.
It satisfies both the goals of business organizations
i.e. to earn the profit and
to achieve optimal relationship in profits earned
and assets employed
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Investment Center
Decision Rights
Input Mix Labor, Material, Supplies
Product Mix
Selling Price
Capital Investment

Performance Measures
Actual ROI
Actual Residual Income i.e. EVA
Actual ROI & RI in comparison with budgeted ROI & RI

Typically used when


RC manager has knowledge about correct price/quantity
RC manager has knowledge to select optimal product mix
RC manager has knowledge about investment

opportunities
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Return on Investment
Return on Investment Relating the profits of a firm with the
investment made.
ROI can be computed in many different ways
depending upon the need and relevance.

1. Return on Assets - ROA


2. Return on Capital Employed - ROCE
3. Return on Shareholders Equity - ROE
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Return on Investment

Return on Assets

Net Profit
1) Return on Assets = --------------- * 100
Assets
ROI terminology would change depending on
what Assets base one takes for computation;
it can be Total Assets,
Fixed Assets,
Gross Assets,
Net Assets,
Tangible Assets or
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Employed Assets

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Return on Investment

Return on Capital

Employed

Net Profit
2) Return on Capital Employed = ------------------------- *
100
Capital Employed
Capital implies the long term
funds
supplied by creditors &
Alternatively it can be
owners
Net Working Capital + Fixed
Assets
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Return on Investment

Return on Shareholders

Equity

Net Profit
3) Return on Shareholders Equity = ---------------- * 100
Equity Capital
Equity includes the preferential capital, however the
ordinary shareholder bears the entire risk.
Net Worth represents the equity capital plus the reserves
and surpluses the portion solely represented by equity
holders.

Net Profit- Pref. Divi.


Return on Shareholders Equity = ------------------- * 100
Net Worth
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Economic Value Added - EVA (Stern &


Stewart)

As lender require certain interest on their

money, owners too expect certain rate of


return on their funds. (taken together both
termed as cost of capital).

Hence no "real" money is made or value is

created until the operating profits exceed the


rupee return required by the owner and the
Increase in EVA, Increase in Market Value of
lenders.
the firm

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Economic Value Added


Stewart)

EVA

(Stern &

EVA is another of the way to relate profits to assets


employed.
Economic Value Added = Net Profit Capital Charge

Capital Charge = Capital Employed * Cost of Capital


EVA=Net profit (Cost of Capital * Capital Employed)
This is nothing but Residual Income which adds to
the value of the firm

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Return on Investment V/s


Economic Value Added
1. ROI is a ratio.
Simple & easy to
understand,
Meaningful in
absolute sense.
Being a common
denominator of
industries it can used
for comparison.

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1. EVA is Profitability
measure in money
term. Can not be
used for comparison
with other Business
Unit or Industries.

Return on Investment V/s


Economic Value Added
2. Different ROI %
provides different
incentives across
BUs
(e.g. BU having current
ROI of 30 will be
discouraged to go for
additional investment
giving 25% ROI, even
though the ROI is greater
than Cost of Capital OR

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BU mgr can improve its


ROI by just disposing the
assets
which give lesser
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ROI than current one)

2. EVA provides an
effective measure
than ROI. EVA
Stresses upon
recovery of cost of
capital. And
welcomes every
rupee earned over
and above COC.

Return on Investment V/s


Economic Value Added
3. ROI does not allow
different treatment
for different kind of
assets i.e. it treats all
assets/investments
at par.

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3. EVA enables to use


different rates of
interest for different
types of assets
involving different
risks. e.g. low rate for
inventory investment
whereas higher rate
for fixed investment.

Return on Investment V/s


Economic Value Added
4. It is difficult to
define an explicit
relationship between
ROI and Market value
of the firm. (ROI not
necessarily indicate
the market value of
the firm.)

EVA has got strong &


positive correlation
with market value of
the firm.

(shareholders worth maximization may not be suitable measure for RCs performance evaluation
Because it is consolidated effect of entire company)

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Return On Investment

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Momence Associates is evaluating the performance of


three divisions: Maple, Oaks, and Juniper. Using the
following data, compute the return on investment and
residual income for each division, compare the divisions
performance, and comment on the factors that influenced
performance.

Maple
Sales
Operating income
Assets invested
Desired ROI
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$100,000
$ 10,000
$ 25,000
40%

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Oaks
$100,000
$ 10,000
$ 12,500
40%

Juniper
$100,000
$ 20,000
$ 25,000
40%

Solution Momence Associates is evaluating the performance of three divisions:


Maple, Oaks, and Juniper. Using the following data, compute the return on
investment and residual income for each division, compare the divisions
performance, and comment on the factors that influenced performance.

Sales
Operating income
Assets invested
Desired ROI

Maple
$100,000
$ 10,000
$ 25,000
40%

Oaks
$100,000
$ 10,000
$ 12,500
40%

Juniper
$100,000
$ 20,000
$ 25,000
40%

ROI=Operating Income/Assets Invested


Maple= $10,000/$25,000= 40%
Oaks= $10,000/$12,500= 80%
Residual Income=Operating Income-(Desired ROI x Assets Invested)
Maple= $10,000-(40% x $25,000)= $0
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Oaks= $10,000-(40% x $12,500)= $5,000

Economic Value Added

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E 13. Leesburg, LLP, is evaluating the performance of three


divisions: Lake, Sumter, and Poe. Using the following data,
compute the economic value added by each division and
comment on each divisions performance.
Lake
Sales
$100,000
After-tax operating income $ 10,000
Total assets $ 25,000
$ 12,500
Current liabilities
$ 5,000
Cost of capital
15%

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Sumter
$100,000
$ 10,000
$ 25,000
$ 5,000
15%

Poe
$100,000
$ 20,000
$ 5,000
15%

E 13. Solution

Leesburg, LLP, is evaluating the performance of three


divisions: Lake, Sumter, and Poe. Using the following data, compute the economic
value added by each division and comment on each divisions performance.

Lake
Sales
$100,000
After-tax operating income $ 10,000
Total assets
$ 25,000
Current liabilities
$ 5,000
Cost of capital
15%

Sumter
$100,000
$ 10,000
$ 12,500
$ 5,000
15%

Poe
$100,000
$ 20,000
$ 25,000
$ 5,000
15%

EVA=
After-tax operating income - Cost of capital(TA-CL)
Lake: $10,000 15%($25,000-$5,000) = $7,000
Sumter: $10,000 15%($12,500-$5,000) = $8,875
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Computing EVA for HLL


Calculation of
ROCE

1999

1998

1997

1996

Operation Profit

1,206

956

711

464

- Less
Depreciation

129

101

58

55

- Less Tax Paid

318

286

281

173

11

17

562

361

219

2,118

1,703

1,412

688

19

18

19

22

402.42

306.54

268.28

151

- Less Tax shield


on interest
Net Optg Profit
less adj Taxes
(NOPLAT)
Average Capital
Employed
WACC (%)
Capital Charge
EVA

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351.58
255.46

92.72

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Incremental Analysis in the


Responsibility Center
Incremental analysis is used to find the

impact of changes in costs or revenues,


given a specific potential scenario.
Decisions involving incremental analysis
include the following:
Make or buy (Profit Center)
Sell or process further (Revenue Center)
Special order (Cost Center)
Changes in production and/or technology
(Investment Center)
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. Identify each of the following as a cost


center, a discretionary cost center, a
revenue center, a profit center, or an
investment center.

1.

The manager of center A is responsible for generating cash


inflows and incurring costs with the goal of making money for
the company. The manager has no responsibility for assets.
2. Center B produces a product that is not sold to an external
party.
3. The manager of center C is responsible for the telephone
order operations of a large retailer.
4. Center D designs, produces, and sells products to external
parties. The manager makes both long-term and short-term
decisions.
5. Center E provides human resource support for the other
centers in the company.
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1.

Solution

The manager of center A is responsible for


generating cash inflows and incurring costs with
the goal of making money for the company. The
manager has no responsibility for assets. P
2. Center B produces a product that is not sold to
an external party. C
3. The manager of center C is responsible for the
telephone order operations of a large retailer. R
4. Center D designs, produces, and sells products
to external parties. The manager makes both longterm and short-term decisions. I
5. Center E provides human resource support for
the other
centers in the company. DC`
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44

Identify the most appropriate type of


responsibility center for each of the following
organizational units.
1.

A pizza store in a pizza chain


2. The ticket sales center of a major airline
3. The South American segment of a multinational
company
4. A subsidiary of a business conglomerate
5. The information technology area of a company
6. A manufacturing department of a large corporation
7. An eye clinic in a community hospital
8. The food-service function at a nursing home
9. The food-preparation plant of a large restaurant
chain
10. The catalog order department of a retailer

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Solution
P

1.

A pizza store in a pizza chain

2.

The ticket sales center of a major airline

3.

The South American segment of a multinational

company

I
I

4.

A subsidiary of a business conglomerate

5.

The information technology area of a company

6.

A manufacturing department of a large corporation

7.

An eye clinic in a community hospital

8.

The food-service function at a nursing home

9.

The food-preparation plant of a large restaurant chain

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10. The catalog order department of a retailer


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DC

C
C

A simple summary of the


responsibility centers
Revenue Center

Expense/Cost Centers

Profit Centers

Investment Centers
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Output measured in
monetary terms

Input measured in
monetary terms

Output measured in
monetary terms

Output measured in
monetary terms