Responsibility Centers

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.

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.

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.

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

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. 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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e.g. R&D Project

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 considered

Cost Center
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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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

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
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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Economic Value Added

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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