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# Atkinson, A. A., R. D. Banker, R. S. Kaplan and S. M. Young. 2001. Management Accounting: 3rd edition. Upper Saddle River: NJ: Prentice Hall.

Chapter 12
Responsibility Centers and Financial Control

Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

1. Introduction

This chapter covers several topics including profit analysis related to cost variances, decentralization and responsibility accounting, transfer pricing, evaluating investment centers with return on investment and residual income, and the efficacy of the financial control methodology.

2. Summary of Variances

Profit analysis includes both revenue and cost variances. Differences between the master budget and actual performance are caused by two things:

1. differences between budgeted and actual sales volumes, and

2. price and cost differences, i.e., differences between budgeted and actual sales prices and differences between budgeted and actual unit cost.

Profit analysis separates the variances to isolate these effects.

Variance analysis can be viewed from several perspectives. The following table provides an equation approach and shows the various levels of analysis and how each variance is calculated. An income statement approach is shown by ABKY on page 512 and in 3b. below. ABKY do not include the sales revenue variances in their example. (See a simple example of profit analysis from MAAW's Chapter 13 that includes sales revenue.)

 Level Two Variances Level Two Variances Separated for Sales Price and Unit Cost Differences and Sales Volume Differences Level Three Variances Level Three Variances Separated for Price and Quantity Differences Flexible budget or Price-Cost Variance (ACM-BCM)(AU) Sales Price Variance (AP-BP)(AU) Unit Cost Variance (AV-BV)(AU) Direct Materials Variance DM Price Variance (AMP-SMP)(AQp) or (AMP-SMP)(AQu) DM Use or Quantity Variance (AQu-SQ)(SP) Direct Labor Variance DL Rate Variance (AR-SR)(AH) DL Efficiency Variance (AH-SH)(SP) Support Cost or Variable Overhead Variance Planning or Sales Volume Variance (AU-BU)(BCM) Revenue part of Sales Volume Variance (AU-BU)(BP) Cost part of Sales Volume Variance (AU-BU)(BV)

AU = Actual units sold for individual products.
BU = Budgeted units sold for individual products.
AP = Actual average sales price for individual products.
BP = Budgeted sales price for individual products.
AV = Actual unit variable cost for individual products.
BV = Budgeted unit variable cost for individual products.
ACM = Actual contribution margin per unit for individual products.
BCM = Budgeted contribution margin per unit for individual products.
AMP = Actual Direct Materials price.
SMP = Standard Direct Materials price.
AQp = Actual quantity purchased.
AQu = Actual quantity used.
AH = Actual hours used.
SH = Standard hours allowed.

3A. Example - Data for Canning Cellular Services

Budgeted and actual unit sales (customers serviced) are indicated below along with aggregated variable (flexible) costs and level one variances.

 Data Budget Actual Variance Unit sales 1,000,000 1,100,000 100,000 Sales revenue Not provided Not provided Not available Variable costs 95,500,000 102,300,000 6,800,000

AU = Actual units sold for individual products = 1,100,000.
BU = Budgeted units sold for individual products = 1,000,000.
AP = Actual average sales price for individual products = not available.
BP = Budgeted sales price for individual products = not available.
AV = Actual unit variable cost for individual products = 93.00.
BV = Budgeted unit variable cost for individual products = 95.50.
ACM = Actual contribution margin per unit for individual products = not available.
BCM = Budgeted contribution margin per unit for individual products = not available.
AMP = Actual Direct Materials price = 27.
SMP = Standard Direct Materials Price = 25.
AQp = Actual quantity purchased = 1,1,00,000.
AQu = Actual quantity used = 1,1,00,000.
AH = Actual hours used = 495,000 for Sales staff and 242,000 for Tech staff.
SH = Standard hours allowed = 550,000 for Sales staff and 275,000 for Tech staff.

3b. Canning Cellular Services Aggregated Level Two variances

The income statement approach to profit analysis shown below, and in more detail on page 512 of ABKY, is a popular way to present variance analysis. The master budget is presented on the left side and the actual results are shown on the right. To isolate the effects of sales volume and price and costs, a flexible budget is placed between the budgeted and actual results (column 3). Then the sales volume, or planning variances are the differences between columns 1 and 3, and the flexible budget or price and cost variances are the differences between columns 5 and 3.

 Data Master Budget 1 Planning or Sales Volume Variances 2 = 1 vs. 3 Flexible Budget* 3 Flexible Budget or Price-Cost Variances 4 = 5 vs. 3 Actual Results 5 Unit sales 1,000,000 100,000 1,100,000 - 1,100,000 Sales Not available Revenue part of Sales Volume variance Not available Sales Price Variance NA Variable costs 95,500,000 Cost Part of Sales Volume Variance 9,550,000U 105,050,000 Unit Cost Variance 2,750,000F 102,333,000 Contribution margin Not available Not available Not available Not available Not available

* A flexible budget is a budget based on the actual level of activity, i.e., the actual sales level in this example. Column 3 represents a flexible budget. The flexible budget amount for the cost row is (1,100,000)(95.50) = 105,050,000.

3c. Canning Cellular Services Summary of Variances

This example shows how the flexible budget variances for costs (or unit cost variances) can be decomposed into variances for direct materials, direct labor and support costs. This level three, more detailed analysis is shown on the right side of the table.

 Level Two Variances Level Two Variances Separated for Sales Price and Unit Cost Differences and Sales Volume Differences Level Three Variances Level Three Variances Separated for Price and Quantity Differences Flexible budget or Price-Cost Variance (ACM-BCM)(AU) Sales Price Variance (AP-BP)(AU) Unit Cost Variance (AV-BV)(AU) (93-95.50)(1,100,000) = 2,750,000 Favorable Direct Materials Variance 2,200,000U DM Price Variance (AMP-SP)(AQp) or (AMP-SP)(AQu) (27-25)(1,100,000) = 2,200,000 U DM Use or Quantity Variance (AQu-SQ)(SP) (1,100,000-1,100,000)(25) = 0 Direct Labor Variance 990,000U DL Rate Variance (AR-SR)(AH) Sales staff (30-25)(495,000) = 2,475,000U Tech Staff (45-40)(242,000) = 1,210,000U Total 3,685,000U DL Efficiency Variance (AH-SH)(SR) Sales staff (495,000-550,000)(25) = 1,375,000F Tech staff (242,000-275,000(40) = 1,320,000F Total 2,695,000F Support Cost Variance 5,940,000F Planning or Sales Volume Variance (AU-BU)(BCM) Revenue part of Sales Volume Variance (AU-BU)(BP) Cost part of Sales Volume Variance (AU-BU)(BV) (1,100,000-1,000,000)(95.50) = 9,550,000 Unfavorable

4. Decentralization and Responsibility Centers

Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, therefore they must be decentralized or separated into manageable parts. These parts, or segments are referred to as responsibility centers and include:

1. revenue centers,
2. cost centers,
3. profit centers and
4. investment centers.

This approach allows responsibility to be assigned (not delegated*) to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such as a division of a company where the manager controls the acquisition and utilization of assets, as well as revenue and costs). These concepts are summarized by ABKY in Exhibit 12-15 and in a similar exhibit below.

 Types of Responsibility Centers Traditional Evaluation (Control) Methods 1. Revenue Centers - segments that mainly generate revenue with relatively little costs. Includes marketing functions only with very little costs relative to the revenue produced. Sales: Sales Variances Sale price variances Sales volume variances 2. Cost Centers - segments that generate costs, but no revenue. Includes production and service functions or departments. Costs: Cost Variances:For purchasing & production departmentsMaterial price variancesMaterial quantity variancesDirect labor rate variances Direct labor efficiency variancesVariable overhead budget variancesFixed overhead budget variancesProduction volume variances For service departments Spending variances 3. Profit Centers - segments that generate both revenue and costs. Includes both marketing, production and service functions. Examples include a manufacturing plant or product line. Gross profit or contribution margin, operating income and net income plus the variances for sales and cost such as the ones above. 4. Investment Centers - segments such as divisions of a company where the managers control the acquisition and utilization of assets, as well as revenue and costs. Includes all the functions above plus the managers control what to produce and how to produce, i.e., have autonomy or more autonomy than profit center managers. Typically, investment centers are divisions of large companies. Return on Investment: = (Return on Sales)(Capital Turnover) = (Net income ÷ Sales)(Sales ÷ Total assets) = Net income ÷ Total assets Also Residual Income. This is essentially the same as economic value added (EVA).

Responsibility accounting is based on the controllability principle. The idea is that managers should only be evaluated based on what they can control. One problem with this approach is that there is a great deal of interdependence within any organization. This interdependence creates joint responsibility across segments that is difficult to separate. In addition, since the parts of an organization cannot be entirely independent, they tend to affect each other in ways that influence the performance measurements in the exhibit above. Evaluating the various segments of an organization separately tends to create competition between them and prevent the company from optimizing the performance of the whole. For example, the segment reporting illustration in ABKY Exhibit 12-16 shows the allocation of some common, or joint costs to the segments of an automobile dealership. A problem that frequently arises involves disputes between responsibility center managers related to how those costs are allocated. Another problem involves transfer pricing disputes.

5. Transfer Pricing

A transfer price refers to the price used for intra-company transfers, i.e., transfers between segments of a company. The term transfer pricing normally means pricing transfers between divisions, but could be used in any situation where the output of one segment (e.g., department, operation, process) becomes the input for another segment within the same company. An example on page 536 of ABKY makes this point with an automobile dealership. A transfer price, or value for a used car is needed when it is transferred from the new car department (as a trade-in) to the used car department. The new car department would like for the value to be high, while the used car department would prefer a low value.

Three Decisions

A transfer pricing situation usually involves three questions or decisions.

1. Should the transfer take place? This is essentially a (Make or Buy) question. Should the company make the item or purchase it on the outside market? This is a relevant cost problem (also referred to as differential or incremental cost). The key is which costs will be different under the two alternatives, i.e., make inside and transfer, or buy from outside the company?

2. If the answer to question one is yes, then what transfer price should be used?

3. Should the central office interfere in establishing the transfer price?

Objectives of Transfer Prices

The overall objective is to establish a transfer price that will motivate effort and goal congruence. There are at least three underlying objectives.

1. To aid in evaluating segment performance, i.e., investment centers or profit centers. If the divisions are treated as investment centers, then Return on Investment (ROI) and Residual Income (RI) are the relevant measurements. For profit centers, contribution margin, segment margin, or net income would be a more appropriate measurement.

2. To maintain division autonomy. Since autonomy means decentralization and freedom to make decisions, it is also an ingredient in motivating effort. Remember, however, that effort and goal congruence are different. Managers may exert considerable effort in pursuing their own goals that conflict with the goals of the firm. Central office interference in a transfer pricing dispute will affect autonomy and effort. The dilemma is that goal congruent behavior may not be obtained with or without interference.

3. To provide the buying segment with needed economic information, i.e., the information necessary for the make or buy question. Intra-company profits included in a transfer price make it impossible for the buying division to answer the make or buy question.

Possible Transfer Prices

1. Market prices. A market price is considered best if the market is perfectly competitive, i.e., if a single buyer or seller cannot affect the price. Generally intra-company transfers at market prices accomplish objectives 1 and 2, but not 3. Unfortunately, several problems occur when trying to use market prices:

a. Most markets are not perfectly competitive. The demand curve and price structure may shift if the firm buys outside.

b. Market prices may not exist for some products.

c. A market price may not be comparable because of differences in quality, credit terms, or extra services provided.

d. Price quotations may not be reliable because they are based on temporary distress or dumping conditions.

e. A market price may not be relevant because the selling division would not have the same transportation cost, accounting cost for A/R, credit etc. as an outside supplier.

f. Information for the make or buy decision would not be available to the buying division.

2. Full cost. All manufacturing, selling and administrative cost are included. Problems that occur when full cost is used as a transfer price:

a. Transfer prices based on full cost do not accomplish any of the objectives stated above. The selling division could not be evaluated as a profit center or investment center since it is treated as a cost center.

b. The seller would be motivated to over allocate cost to the product transferred.

c. If actual cost are transferred, the cost of inefficiency will be passed along to the buying division. Thus, standard cost make better transfer prices although standards may be rigged.

d. The buyer would not have the differential cost information needed for the overall firm make or buy decision. The irrelevant common fixed cost of the seller become relevant cost to the buyer.

3. Full Cost Plus. All manufacturing, selling and administrative cost plus a markup for profit. Standard cost plus would be better than actual cost plus to motivate the seller to be an efficient cost producer. The same problems in 2 are applicable here. Motivation for over allocation is still present. Transfers at standard could motivate the seller to rig the standard.

4. Variable cost. All variable manufacturing, selling and administrative cost. This may come close to accomplishing objective 3, since variable cost may approximate differential cost. Objectives 1 and 2 would not be obtained since the other problems listed under 2 and 3 are applicable here, lack of motivation for profits, potential for cost over allocation etc.

5. Variable cost plus. This may be a little better than 4, but the plus should be kept separate to allow for a ball park make or buy decision. Objectives 1 and 2 would not be fully obtained.

6. Negotiated price. Negotiated prices may be best if:

a.) An imperfect market exist for the product making it difficult, if not impossible, to determine the appropriate market price.

b.) The seller has excess capacity, thus the transfer becomes a relevant cost problem to the seller. Any transfer price above the seller's differential cost would benefit the seller.

c.) There is no external market for the product, thus no market price.

In these cases the buyer and seller may negotiate a price that allows both parties to share in the benefits of the transfer. This may accomplish objectives 1 and 2, but not 3. A problem with this approach is that managers may spend a substantial amount of time and effort negotiating transfer prices.

7. Dual Price. Use two transfer prices. Give the seller credit for selling at market price or full cost plus a reasonable markup, but charge the buyer with variable cost (i.e., approximate differential or additional outlay cost). Charge the difference to a central account. This approach may not motivate either the seller or the buyer to be efficient.

8. Administered - Use an arbitrator to set the price based on a rule such as cost plus five percent. This is easy but accomplishes none of the objectives stated above.

6. Evaluating Investment Centers

Investment centers are evaluated with Return on Investment (ROI) and Residual Income or Economic Value Added (EVA)

Return On Investment

To review the idea,

ROI = (Capital turnover ratio)(Profit Margin on Sales) = (Sales ÷ Investment)(Net Income ÷ Sales)

The Capital Turnover Ratio reflects management's ability to generate sales from a given investment base and reflects the overall productivity of the segment. Note that the source of the investment (i.e., debt or stockholders equity) is usually considered irrelevant, but see the alternatives below. Productivity is generally defined as some measure of output per input. In the ROI measurement, output is defined in terms of sales dollars and inputs are typically represented by total assets.

The Profit Margin is the rate of return on sales (ROS) and measures management's ability to control the spread between prices and costs. Efficiency and cost control are reflected in this measure as well as other factors such as productivity and the sales level. Productivity in this measurement refers to the quantity of products or services produced per input, such as per headcount.

ROI may be increased in various ways. Some possibilities include the following.

1. Increasing Capital Turnover.
a. Increase sales with the same investment base.
b. Decrease the investment base with the same sales level.

2. Increasing Profit Margin or ROS.
a. Increase prices with no unfavorable effects on sales.
b. Decrease cost with no unfavorable effects on quality or increase in assets employed.
c. Increase sales with no changes in prices or costs.

Residual Income or Economic Value Added

Residual income or economic value added is calculated as follows:

RI or EVA = Income - the cost of capital, or minimum desired rate of return

The minimum desired rate of return used in the RI or EVA calculation is usually referred to as the cost of capital which is a weighted average measure of the cost of long term debt and stockholders' equity.

Maximizing ROI and RI are different objectives.

Using ROI as a performance measurement may cause many managers to reject profitable projects if the projects would tend to lower the ROI. As a result, a conflict arises between the goals of the manager and the goals of the organization, i.e., goal congruence is not obtained.

ABKY example on page 549. Assume that a division has a cost of capital, or minimum desired rate of return, of 10 percent, income of 13.5 million and 100 million in capital.

ROI = 13.5/100 = .135 or 13.5%

RI or EVA = 13.5 - .1(100) = 3.5 million

Would a manager evaluated on the basis of the ROI accept a new project with an expected return of 11, 12 or 13 percent? Probably not, since it would reduce the division's overall ROI below the current 13.5%.

Would the manager accept the project if RI is used as the evaluation measurement. Yes, since the return is above 10%, it would increase the division's residual income.

Separate problem for RI users

Using Residual Income avoids the problem stated above, but creates a different problem. Using RI makes it difficult to compare the performance of different size divisions.

7. The Efficacy of Financial Control

Managing an organization with financial information has been criticized by many leading management researchers and theorist. For example, Deming included placing emphasis on short term profits and running the company on visible figures alone as deadly diseases. ABKY discuss three problems with financial control.

1. Financial control does not measure other important attributes such as the quality of products and services, the time required to develop new products and services, the quality of the work environment and many other critical non-financial factors.

2. Financial control measures the overall level of performance, but does not help the company improve. Johnson refers to this as placing the cart in front of the horse. For improvement, the emphasis needs to be on the processes and work that people do (the horse), not the financial results (the cart).

3. Since financial control is usually oriented towards short term profits, managers and workers are motivated to do things to improve short term results that hurt the long run performance of the organization.

See the following for more on the criticisms of financial control: Summary of Deming's The New Economics and Summary of Johnson's Relevance Regained.

8. Questions

1. What does financial control mean? (See Chapter 9 summary and Chapter 1 item 7 for examples).

2. How does analysis of reasons for variances between actual and estimated costs help managers? (See the graphic view of profit variances for some ideas).

3. What is a flexible budget? (See below table in 3b above and MAAW's Chapter 13 example that includes a flexible budget for sales revenue). (See MAAW's Chapter 10 Class problem exhibits related to material and labor for many other flexible budgets).

4. How are first, second, and third levels of variance analysis related? (See item 2 above).

5. Why is it useful to decompose a flexible budget variance into a price variance and efficiency (use) variance. (See item 2 above and the graphic view of profit variances for some ideas).

6. "If more experienced workers work on the job than planned in developing the labor standards, the labor efficiency variance is likely to be favorable but the labor wage (rate) variance is likely to be unfavorable." Do you agree with this statement? Explain. (See item 3c above or MAAW's Chapter 10 exhibit related to labor).

7. What effect will the purchase and use of cheaper, lower-quality materials likely have on price and use components of both materials and labor variances? (See item 3c above or MAAW's Chapter 10 exhibit related to material).

8. What is decentralization? (See item 4 above).

9. What does control mean in a decentralized organization? (See the table under item 4 above).

10. What is a responsibility center? (See item 4 above).

11. What is a cost center? (See the table under item 4 above).

12. What is the assigned responsibility in a revenue center? (See the table under item 4 above).

13. When do organizations use profit centers? (See the table under item 4 above).

14. What is an investment center? (See the table under item 4 above).

15. What does the controllability principle require? (See item 4 below table).

16. How do responsibility centers interact? (See item 4 below table).

17. What does segment margin mean?

18. What is a soft number in accounting?

19. What is a transfer price? (See item 5 above).

20. What are four bases for setting a transfer price? (See list of possible transfer prices above, but note that one category includes several alternatives).

21. Why do organizations allocate revenues to responsibility centers?

22. Why do organizations allocate costs to responsibility centers?

23. What is return on investment? (See item 6 above).

24. How does efficiency (the ratio of operating income to sales) affect return on investment? (See item 6 above). (Also see the ROI Read diagram). (See the limit for ROS).

25. How does productivity (the ratio of sales to investment) affect return on investment? (See item 6 above). (Also see the ROI Read diagram).

26. What does economic value added mean? (See item 6 above).

27. What are three reasons financial control alone may provide an ineffective control scorecard? (See item 7 above).

* One person can delegate authority to another to act on his or her behalf, but one person's responsibility can not be delegated to another person. For example, an individual can hire a tax service to prepare the taxpayer's return, but the taxpayer is still responsible.

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