Summary of Chapter 4

Responsibility Centers: Revenue and Expense Centers

Nature of Responsibility Centers A responsibility center exists to accomplish one or more purposes, termed its objectives. The objectives of the companys various responsibility centers are to help implement these strategies.

Relation between Inputs and Outputs Management is responsible for ensuring the optimum relationship between inputs and outputs. In some centers, the relationship is casual and direct, as in a production department. In many situations, however, inputs are not directly related to outputs.

Inputs
Resources used, measured by cost

Outputs

Work

Goods or Services

Measuring Inputs and Outputs In management control system these quantitative amounts are translated into monetary terms; money is a common denominator that allows the value of several different resources to be combined or compared. Cost is a monetary measure of the amount of resources used by a responsibility center.

Efficiency and Effectiveness The concepts of input, output, and cost can be used to explain the meaning of efficiency and effectiveness. Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input. Effectiveness is determinate by the relationship between a responsibility centers output and its objectives. The more this output contributes to the objectives, the

more effective the unit. A responsibility center is efficient if it does things right, and it is effective if it does the right things.

TYPES OF RESPONSIBILITY CENTERS There are four types of responsibility centers, classified according to the nature of the monetary inputs or outputs that are measured for control purpose : a) Revenue centers In a revenue center, output is measured in monetary terms, but formal attempt is made to relate input. Revenue centers are marketing or sales units that do not have authority to set selling prices and are not charged for the cost of the goods they market. b) Expense centers Expense centers are responsibility centers whose inputs are measured in monetary terms, but whose outputs are not. There are 2 general types of expenses centers : 1. Engineered expense centers Engineered expense centers have the following characteristic : Input can be measured in monetary terms Output can be measured in physical terms The optimum dollar amount of input required to produce one unit of output can be determined. 2. Discretionary expense centers Discretionary expense centers include administrative and support units. The output of these centers cannot be measured in monetary terms. In a discretionary expense centers, the difference between budget and actual expense is not measure of efficiency c) Profit centers d) Investment centers

Management control system for discretionary expense in general characteristics The planning function for discretionary expense centers is usually carried in : a) Incremental budgeting In this model, the Discretionary expense centers current level of expenses is taken as a starting point

b) Zero base review This analysis establishes another new base, at which point the annual budget review simply attempts to keep costs reasonably in line with this base until the next review take place.

There are 3 common types of discretionary expense centers : 1. Administrative and Support Centers The control of administrative expense is especially difficult because of : The problems inherent in measuring output The frequent lack of congruence between the goals of departmental staff and of the company as a whole 2. Research and Development Center The control of research and development centers presents its own characteristic difficulties, such as : 3. Difficulty in relating results to inputs Lack of goal congruence

Marketing Centers There are 3 types of activities within a marketing organization, and consequently three types of activity measures. First, there is the order filling or logistics activity. Second, there is the generation of revenue, which is usually evaluated by comparing actual revenue and physical quantities sold with budgeted revenue units respectively. Third, there are order-getting costs, which are discretionary because no one knows what the optimum should be. Consequently, the measurement of efficiency and effectiveness for these costs is highly subjective.

Summary of Chapter 5

Profits Centers
When a responsibility centers financial performance is measured in terms of profit (the difference between the revenues and expenses), the center is called a profit center. A functional organization is one of which each principal manufacturing or marketing function is performed by a separate organization unit. When such an organization is converted to one in which each major unit is responsible for both the manufacture and the marketing, the process is termed divisionalization.

Advantages of Profit Centers 1. The quality of decisions may improve because they are being made by managers closest to the point of decision. 2. The speed of operating decisions may be increased since they do not have to be referred to corporate headquarters. 3. 4. 5. 6. Headquarters management can concentrate on broader issues. Managers are freer to use their imagination and initiative. Profit centers provide an excellent training ground for general management. Profit consciousness is enhanced since managers who are responsible for profits will constantly seek ways to increase them. 7. 8. Profit centers provide top management with ready-made information Profit centers are particularly responsive to pressures to improve their competitive performance.

Difficulties with Profit Centers 1. Decentralized decision making will force top management to rely more on management control reports than on personal knowledge of an operation, entailing some loss of control. 2. The quality of decisions made at the unit level may be reduced if headquarters management is more capable informed than the average profit center manager. 3. Friction may increase.

4.

Organization units that once cooperated as functional units may now be in competition with one another.

5. 6. 7.

Divisionalization may impose additional costs. Competent general managers may not exist in a functional organization. There may be too much emphasis on short-run profitability at the expense of longrun profitability.

8.

There is no completely satisfactory system for ensuring that optimizing the profits of each individual profit center will optimize the profits of the company as a whole.

Business Units as Profit Centers 1) Constrains from Other Business Units It is useful to think of managing a profit center in terms of control over three types of decision : a. The product decision (what goods/services to make and sell) b. The marketing decision (how, where, and for how much are these goods/services to be sold) c. The procurement or sourcing decision (how to obtain or manufacture the goods or services) 2) Constrains from Corporate Management The constraints imposed by corporate management can be grouped into three types: a. Those resulting from strategic considerations b. Those resulting because uniformity is required c. Those resulting from the economies of centralization.

OTHER PROFIT CENTERS Functional Units a. Marketing A marketing activity can be turned into a profit center by charging it with the cost of the products sold. The transfer price charged to the profit center should be based on the standards cost, rather than the actual cost, of the products being sold. b. Manufacturing

The manufacturing activity is usually an expense center, with the management being judged on performances versus standards costs and overhead budgets. Where performance of manufacturing process is measured against standard costs, it is advisable to make a separate evaluation of such activities as quality control, production scheduling, and make-or-buy decisions. c. Service and Support Units Units for maintenance, information technology, transportation, engineering, consulting, customer service, and similar support activities can all be made into profit centers. When service units are organized as profit centers, their managers are motivated to control costs in order to prevent customers from going elsewhere, while managers of the receiving units are motivated to make decisions about whether using the service is worth the price.

Other Organizations A company with branch operations that are responsible for marketing the companys products in a particular geographical area is often a natural for a profit center. Even though the branch managers have no manufacturing or procurement responsibilities, profitability is often the best single measure of their performance.

Measuring Profitability There are two types of profitability measurements used in evaluating a profit center : 1. Management performance 2. Economic performance

Types of Profitability Measures The performance of the profit center manager may be evaluated by five different measurement of profitability: 1. Contribution Margin 2. Direct Profit 3. Controllable Profit 4. Income before Taxes 5. Net Income