responsibility center

Responsibility Center

Responsibility AccountingResponsibility accounting is used to measure

the performance of people and departments to foster goal congruence.

Responsibility CentersA subunit in an organization whose

manager is held accountable for specified financial results.

Responsibility Centers Cost Center

Segment has control over

the incurrence of costs.

The Paint Departmentin an automobile plant.

Revenue Center Segment

is responsiblefor the revenue of

a unit.

The ReservationsDepartment of an airline.

Responsibility Centers

Profit Center Segment has

control over both costs and

revenues.

Company-owned restaurant in a fast-food

chain.

Investment Center Segment has control over profits

and invested capital.

A division of alarge corporation.

Performance Reports

Show the budgeted and actual amounts, and the variances

between these amounts, of key financial results appropriate for the type of responsibility center.

Performance ReportsFebruary Year to Date February Year to Date February Year to Date

Company . . . . . . . . . . . . . . . . . . . . . . $30,660 $64,567 $30,716 $64,570 $56 F $ 3 FMaui Division . . . . . . . . . . . . . . . . . . $18,400 $38,620 $18,470 $38,630 $70 F $10 FOahu Division . . . . . . . . . . . . . . . . . . 12,260 25,947 12,246 25,940 14 U 7 UTotal profit . . . . . . . . . . . . . . . . . . . . $30,660 $64,567 $30,716 $64,570 $56 F $ 3 FOahu DivisionWaimea Beach Resort . . . . . . . . . . . $6,050 $12,700 $6,060 $12,740 $10 F $40 FDiamond Head Lodge. . . . . . . . . . . 2,100 4,500 2,050 4,430 50 U 70 UWaikiki Sands Hotel . . . . . . . . . . . . . 4,110 8,747 4,136 8,770 26 F 23 FTotal profit . . . . . . . . . . . . . . . . . . . . $12,260 $25,947 $12,246 $25,940 $14 U $ 7 UWaikiki Sands HotelGrounds and Maintenance . . . . . . . . ($45) ($90) ($44) ($90) $ 1 F —Housekeeping and Custodial . . . . . . (40) (90) (41) (90) 1 U —Recreational Services . . . . . . . . . . . . 40 85 41 88 1 F $ 3 F Hospitality . . . . . . . . . . . . . . . . . . . . 2,800 6,000 2,840 6,030 40 F 30 F Food and Beverage . . . . . . . . . . . . . 1,355 2,842 1,340 2,832 15 F 10 U Total profit . . . . . . . . . . . . . . . . . . . . $4,110 $8,747 $4,136 $8,770 $26 F $23 F Food and Beverage DepartmentBanquets and Catering . . . . . . . . . . . $600 $1,260 $605 $1,265 $ 5 F $ 5 F Restaurants . . . . . . . . . . . . . . . . . . . 1,785 3,750 1,760 3,740 25 U 10 U Kitchen. . . . . . . . . . . . . . . . . . . . . . . (1,030) (2,168) (1,025) (2,173) 5 F 5 U Total profit . . . . . . . . . . . . . . . . . . . . $1,355 $2,842 $1,340 $2,832 $15 U $10 U KitchenKitchen staff wages . . . . . . . . . . . . . ($80) ($168) ($78) ($169) $ 2 F $ 1 U Food . . . . . . . . . . . . . . . . . . . . . . . . (675) (1,420) (678) (1,421) 3 U 1 U Paper products. . . . . . . . . . . . . . . . . (120) (250) (115) (248) 5 F 2 F Variable overhead. . . . . . . . . . . . . . . (70) (150) (71) (154) 1 U 4 U Fixed overhead. . . . . . . . . . . . . . . . . (85) (180) (83) (181) 2 F 1 U Total expense . . . . . . . . . . . . . . . . . . ($1,030) ($2,168) ($1,025) ($2,173) $ 5 F $ 5 U

*Numbers w ithout parentheses denote profit; numbers w ith parentheses denote ex penses; numbers in thousands.

†F denotes fav orable v ariance; U denotes unfav orable v ariance.

Flexible Budget* Actual Results* Variance†

INVESTMENT CENTER

S upervisor S upervisor

M iddleM anagem ent

S upervisor S upervisor

M iddleM anagem ent

T opM anagem ent

Decision Makingis pushed down.

Delegation of Decision Making(Decentralization)

Decentralization often occurs as organizations continue to grow.

Decentralization

AdvantagesAllows organization

to respond morequickly to events.

Frees top managementfrom day-to-day

operating activities.

Uses specializedknowledge and

skills of managers.

Decentralization

ChallengeGoal Congruence:

Managers of the subunits make decisions that achieve

top-management goals.

Measuring Performancein Investment Centers

Investment Center managers make decisions that

affect both profit and invested

capital. Corporate Headquarters

InvestmentCenter

Evaluation

Return on investment, residual income, or

economic value added

Return on Investment (ROI)

ROI = IncomeInvested Capital

ROI = IncomeSales Revenue × Sales Revenue

Invested Capital

SalesMargin

CapitalTurnover

Holly Company reports the following:

Income $ 30,000Sales Revenue $ 500,000Invested Capital $ 200,000

Let’s calculate ROI.



Invested Capital


ROI = $30,000$500,000 × $500,000

$200,000

ROI = 6% × 2.5 = 15%

Economic Value Added

Economic value added tells us how much shareholder wealth is being created.

Economic Value Added Investment center’s after-tax operating income– Investment charge = Economic Value Added

Weightedaverage

cost of capital

Investmentcenter’s

total assets

Investmentcenter’s

current liabilities–( )

After-taxcost ofdebt

Marketvalue

of debt

Cost ofequity capital

Marketvalue

of equity( () )

Marketvalue

of debt

Marketvalue

of equity


The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:

Atlantic's pretax income 6,750,000$ Atlantic's total assets 45,000,000 Atlantic's current liabilities 600,000 Market value of Suncoast's debt 40,000,000 Market value of Suncoast's equity 60,000,000 Interest rate on Suncoast's debt 9%Cost of Suncoast's equity capital 12%Tax rate 30%

Compute Atlantic Division’s economic value added.


(9% × (1 – 30%) × $40,000,000) + (12% × $60,000,000)

$40,000,000 + $60,000,000= 0.0972

First, let’s compute theweighted-average cost of capital


$4,725,000 After-tax operating income– 4,315,680= $ 409,320 Economic value added

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

$40,000,000 + $60,000,000

($45,000,000 – $600,000) × 0.0972 = $4,315,680

= 0.0972

$6,750,000 × (1 – 30%)

Improving R0I

Three ways to improve ROI

Increase Sales Prices

Decrease Expenses

Lower Invested Capital

• Holly’s manager was able to increase sales revenue to $600,000 which increased income to $42,000.

• There was no change in invested capital.

Let’s calculate the new ROI.

Improving R0I


Invested Capital


ROI = $42,000$600,000 × $600,000

$200,000

ROI = 7% × 3.0 = 21% Holly increased ROI from 15% to 21%.

Residual Income Investment center profit– Investment charge = Residual income

Investment capital× Imputed interest rate= Investment charge

Investment center’sminimum required

rate of return

Residual Income

• Flower Co. has an opportunity to invest $100,000 in a project that will return $25,000.

• Flower Co. has a 20 percent required rate of return and a 30 percent ROI on existing business.

Let’s calculate residual income.

Residual Income Investment center profit = $25,000– Investment charge = 20,000= Residual income = $ 5,000

Investment capital = $100,000× Imputed interest rate = 20% = Investment charge = $ 20,000

Investment center’sminimum required

rate of return

Residual Income

• As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income?

• Would your decision be different if you were evaluated using ROI?

Residual IncomeResidual income encourages managers to make profitable investments that would

be rejected by managers using ROI.

Measuring InvestmentCenter 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.

The key issue is controllability.

Transfer Pricing

Let’s change topics!

Transfer Pricing

The amount charged when one division sells goods or services to another division

Battery Division Auto Division

Batteries

The transfer price affects the profit measure for both the selling division and the buying

division.A higher transferprice for batteries

means . . .

greaterprofits for the

battery division.Auto DivisionBattery Division

Transfer Pricing

lower profitsfor the

auto division.

The transfer price affects the profit measure for both the selling division and the buying

division.

Auto DivisionBattery Division

Transfer Pricing

A higher transferprice for batteries

means . . .

Goal Congruence

The ideal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

18-35

To motivate managers. To provide an incentive for

managers to make decisions consistent with the firm’s goals.

To provide a basis for fairly rewarding the managers.

Objectives of Transfer Pricing

These are thesame as the

SBU objectives!

18-36

• Variable cost – sets the transfer price equal to the variable cost of the selling unit.

• Full cost – sets the transfer price as the variable cost plus allocated fixed cost for the selling unit.

• Market price – Set the transfer price as the current price for the selling unit’s product in the market.

• Negotiated price – involves a negotiation process and sometimes arbitration between units to determine the transfer price.

Transfer Pricing Methods

18-37

Choosing the Right Transfer Price

If there is no outside supply . . .

Decision to Transfer: Buy inside. Transfer Price: Cost or negotiated price.

18-38


If there is an outside supply . . .Is the seller’s variable costs < outside

price?

No.

Decision to Transfer: Buy outside. Transfer Price: No transfer price.

18-39


If there is an outside supply . . .Is the seller’s variable costs < outside

price?Yes.

Does seller have excess capacity?Yes.

Decision to Transfer: Buy inside. Transfer Price: Low – variable cost,

High – market price.

18-40


If there is an outside supply . . .Is the seller’s variable costs < outside price?

Yes.Does seller have excess capacity?

No.If contribution from outside purchase > contribution from

inside purchase . . .

Decision to Transfer: Buy outside. Transfer Price: No transfer price.

18-41


If there is an outside supply . . .Is the seller’s variable costs < outside price?

Yes.Does seller have excess capacity?

No.If contribution from outside purchase < contribution from

inside purchase . . .

Decision to Transfer: Buy inside. Transfer Price: Market price.

Conflicts may be resolved by . . .

Direct intervention by top management. Centrally established transfer price

policies. Negotiated transfer prices.

CONFLICTS

An International Perspective

Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will: Increase revenues in low-tax countries. Increase costs in high-tax countries. Reduce cost of goods transferred to high-

import-duty countries.

End of Meeting

Let’s transfer some of yourcapital to me so that my rate

of return will be higher!

responsibility center

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