RESPONSIBILITY CENTERS
P2 Chapter 8
Decentralisation/
Divisionalisation
Meaning Objective Disadvantage
1. Ensure goal
congruence
Creating divisions or 2. Increased Can lead to
departments in an motivation of dysfunctional
organisation to make management decision making,
management easy by 3. Reduce head where divisions work
dividing work office bureaucracy in their own interest
4. Better training for
juniormanagement
Performance evaluation techniques can solve the problem of dysfunctional decision making. It has the
following objectives:
1. Promote goal congruence
2. Encourage initiative and motivation
3. Provide feedback to management
4. Encourage long term views
To achieve these objectives, responsibility centres are introduced.
Responsibility centres
(In responsibility accounting, a specific manager is given responsibility for only their area)
Cost centre Revenue centre Profit centre Investment centre
1. manager responsible 1. Manager only 1. Manager responsible
for operating costs responsible for 1. Manager responsible
for costs, revenues,
revenue for both costs and
2. a production or profits and investment
revenues
service location, 2. Focus not given on returns
function, activity or costs
item of equipment for
3. For instance, sales
which costs are
dept.
accumulated.
3. Can be big or small
Each cost centre, profit centre, revenue centre and investment centre should have its own budget, and its
manager should receive regular budgetary control information relating to the centre, for control and
performance measurement purposes.
Controllability of costs
(All costs are controllable in the long run)
In responsibility accounting, managers can
only be held responsible for the costs that can
be controlled.
Uncontrollable
Controllable costs costs
Variable costs are not always
controllable. For instance, in the A distinction can be made
short run direct labour cost cannot between committed fixed costs
be controlled. and discretionary fixed costs.
Fixed costs that are
Variable costs not directly
attributable
Direcctly
attributable fixed Economic changes
costs
Responsibility accounting
Pros Cons
Profit centre managers made aware of significance Profit centre managers made responsible for
of overhead costs overhead costs that they can’t control
Profit centre managers made aware that they need Overhead apportionment is a matter of judgement
to earn certain profits to cover overhead costs and not always accurate
KEY PERFORMANCE INDICATORS
A budget should not be approved by senior management unless budgeted performance is satisfactory, as
measured by the key metrics. Actual performance should then be assessed in comparison with the targets.
These metrics maybe called key performance indicators. The key financial performance areas in a company
are:
Profitability
Asset
Liquidity
turnover
Profitability
DuPont model – A triangular model for measuring key metrics of profitability
𝑃𝑟𝑜𝑓𝑖𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡
∗ =
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Profit margin * asset turnover = ROCE
Capital employed = equity + long term finance
(Use opening capital employed in exam unless specified)
Liquidity
Better management through efficient cash, inventory, receivables and payables management.
The key metrics for measuring liquidity are:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
And
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The broad rule is having a current ratio between 1 and 2 times
Too little liquidity and too much liquidity are both not good.
Investment metrics
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑟 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 =
𝑑𝑖𝑣𝑖𝑠𝑖𝑜𝑛𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑜𝑙𝑙𝑎𝑏𝑙𝑒 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥
∗ 100
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
ROI / ROCE
Pros Cons
Widely used and accepted May lead to dysfunctional decision making
As a relative measure it enables comparisons to be Different accounting policies can confuse
made comparisons
It can be broken down into secondary ratios ROI increases with the age of the asset if NBVs are
used, thus giving managers an incentive to hang on
to possibly inefficient, obsolescent machines.
Can encourage manipulation of profits
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑝𝑟𝑜𝑓𝑖𝑡 − (𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 ∗ 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙)
Selected cost of capital can be company’s average cost of funds or some other relevant rate such as
borrowing interest rate, etc.
RI
Pros Cons
Encourages managers to take projects that add RI Doesn’t felicitate inter department comparisons
Makes investment centre managers aware of their Different accounting policies can give different
cost of investments estimates
Risk can be incorporated by the choice of interest
rate used: different interest rates for the notional
cost of capital can be applied to investments with
different risk characteristics
DIVISIONAL PERFORMANCE MEASUREMENT
Type of division Description Key metrics
1. Total cost and cost/ unit
2. Cost variances
Incurs cost but doesn’t have
3. Non-financial
Cost centre revenue.
performance indicators
Eg: IT department
related to quality,
productivity, efficiency
Generates revenue, doesn’t incur 1. Total revenue, revenue
Revenue centre costs per unit
Eg: Sales department 2. Revenue variances
1. Total sales and market
share
2. Profit
3. Sales variances
Profit centre Incurs both cost and revenue 4. Working capital ratios
5. Non-finance performance
indicators related to
productivity, customer
satisfaction and quality
Incurs costs and revenues All of the above plus
Investment centre Manager responsible for 1. Return on investment
investment decisions 2. Residual income
1. Variance analysis
2. Ratio analysis
3. Other management ratios
Other measures – profit per employee, etc
4. Other information – staff
turnover, innovative
products launched, etc
ECONOMIC VALUE ADDED
The basic concept of EVA is that the performance of a company as a whole, or of investment centres within
a company, should be measured in terms of the value that has been added to the business during the
period. It is a measure of performance that is directly linked to the creation of shareholder wealth.
Calculation:
PAT is adjusted to give the Net Operating Profit after tax (NOPAT) X
Deduct the economic value of the capital employed(opening CE) × cost of capital (X)
EVA X
In detail:
NOPAT calculated from PAT X
Add back non-cash items
Accounting depreciation X
Provision for doubtful debt X
Non-cash expense X
Interest paid net of tax X
Add back items that add value
Goodwill amortised X
Development costs X
Operating leases X
Take off
Economic depreciation (impairment in goodwill) (X)
=NOPAT in cash flow terms XX
Deduct charge for cost of capital
Capital employed
+ Adjustments to allow for the net replacement cost of tangible non-current assets
= Capital invested
Multiply capital invested by the cost of capital * %
= Charge for the cost of capital (XX)
= EVA X
Advantages of EVA
1. Performance measure that puts a figure to the change in value arisen from the operations of a
company
2. Can be measured for each financial year
3. Based on economic estimates, not accounting
4. Share prices depend on estimated EVA
REPORTS FOR DECISION MAKING
Key principles
Visualisation to
Ensure data is The relevant An appropriate Reader the
optimised for visualisation report layout experience appropriate
report tool must be must be must be delivery
visualisation applied chosen optimised channel must
be optimised
Visualisation tools
Waterfall chart or bridges for variance analysis Dashboards for business segment overview
Line chart for trend analysis Mapping charts for location wise reports
Side by side pie charts for comparing products with components
