Responsibility Center

Decentralization in Organizations

Benefits of
Top management
Decentralization freed to concentrate
on strategy.
Lower-level managers
gain experience in
decision-making. Decision-making
authority leads to
job satisfaction.
Lower-level decisions
often based on
better information. Lower level
managers can
respond quickly to
customers.
 Decentralization in Organizations

May be a lack of
coordination among
autonomous
Lower-level managers
managers.
may make decisions
without seeing the
“big picture.”
Disadvantages of
Lower-level manager’s
Decentralization
objectives may not
be those of the
organization. May be difficult to
spread innovative ideas
in the organization.
 Responsibility Center

 A responsibility center is an organization unit that is

headed by a manager who is responsible for its
activities to achieve certain objectives.
 An organization is a collection of responsibility
centers.
 An organization achieves its goals only if its
responsibility centers achieve their goals.
 Cost, Profit, and Investments Centers

Cost Profit Investment

Center Center Center

Cost, profit,
and investment
centers are all Responsibility
known as Center

responsibility
centers.
 Cost Center

A segment whose manager

has control over costs,
but not over revenues or
investment funds.
 Profit Center

Revenues
A segment whose
Sales
manager has control
Interest
over both costs and
Other
revenues,
but no control over Costs
investment funds. Mfg. costs
Commissions
Salaries
Other
 Investment Center

Corporate Headquarters

A segment whose
manager has control
over costs, revenues, and
investments in operating
assets.
 Responsibility Centers
Investment
Centers Superior Foods Corporation
Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager

Bottling Plant Warehouse

Cost Distribution

Center
Manager Manager Manager

s
Superior Foods Corporation provides an example of
the various kinds of responsibility centers that exist
in an organization.
 Responsibility Centers

Superior Foods Corporation

Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager

Bottling Plant Warehouse Distribution

Profit
Manager Manager Manager
Centers
Superior Foods Corporation provides an example of
the various kinds of responsibility centers that exist
in an organization.
 Responsibility Centers

Superior Foods Corporation

Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager

Bottling Plant Warehouse Distribution

Cost
Centers
Manager Manager Manager

Superior Foods Corporation provides an example of

the various kinds of responsibility centers that exist
in an organization.
 Responsibility Center

 A responsibility center is an organization unit that is

headed by a manager who is responsible for its
activities to achieve certain objectives.
 An organization is a collection of responsibility
centers.
 An organization achieves its goals only if its
responsibility centers achieve their goals.
 Responsibility Centers

 Performance of a responsibility center is measured

by inputs or outputs
 Efficiency and effectiveness
 Efficiency is the ratio of output to input
 Effectiveness is the relationship between output and
its objectives.
 Types of Responsibility Center

 Engineered Expense Center (input in monetary,

output in physical terms)
 Discretionary Expense Center (input measure,
monetary terms)
 Revenue Center (output measure, monetary terms)
 Profit Center (input and output measure, monetary
terms)
 Investment Center
 Expense Centers

 General control characteristics:

 Budget preparations

 Incremental budgeting

 Zero base budgeting

 Performance measurement
 Discretionary Expense Centers

 Administrative and Support Centers

 Difficulty in measuring output

 Goal congruence

 Research and Development Centers

 Difficult to relate output to input

 Goal congruence

 Marketing Centers
 Divisionalization

 A functional vs. divisional organization

 Two conditions for delegation process:
 Lower level managers have access to relevant information.

 There is a method to measure the effectiveness of decisions.

 The trend of divisionalization started in 1950s

 The majority of large companies have more than one
profit centers.
 Advantages of Profit Centers

 Improved decision quality

 Faster operating decision making
 Top managers can focus on strategic issues
 Managers are more empowered
 Training ground for general management
 Enhanced profit consciousness
 Easy to measure performance
 Disadvantages of Profit Centers

 The possibility of loss of control by top management

 The decision quality may be reduced if top
management is more capable than subordinates
 Friction among profit centers
 Additional costs (more staff, redundancies)
 Overemphasis on short-run profitability
 Goal congruence problems
 Managing Profit Center

 Business Units as profit centers have controls over:

 Product decisions

 Marketing decisions

 Procurement or sourcing decisions

 Other profit centers:

 Marketing

 Manufacturing

 Service and support units

 Measuring Profitability

 Management vs. economic performance

 Management performance measures:
 Contribution margin

 Direct profit

 Controllable profit

 Income before income tax

 Net income

 Revenue recognition problems

 Transfer Price

 Transfer price is the amount charged for goods or

services transferred between responsibility centers.
 Objectives of transfer prices:
 Provide information on costs & revenues
 Promote goal congruence
 Help measure economic performance
 Simple and easy to implement
 Transfer Pricing Principles

 Transfer price should be similar to market price.

 Two decisions:
 Sourcing (buy or make) decision

 Transfer price decision

 Ideal situation:
 Good atmosphere

 A market price

 Freedom to source

 Full information

 Negotiation
 Possible Transfer Prices

 Possible market prices:

 Published market price

 Bids price

 Selling price in the production profit center

 Buying price of the buying profit center

 Cost-based transfer price

 Cost basis

 Mark-up
 Administration of Transfer Price

 Negotiation
 Arbitration and conflict resolution
 Product classification
 Investment center

 A special type of profit center

 Has control over investment decision
 Measures of performance:
 Return on investment

 Residual income

 Economic value added

 Measuring Assets Employed

 Cash
 Receivables
 Inventories
 Working capital
 Property, Plant and Equipment
 Acquisition of new equipment
 Gross book value
 Disposition of assets
 Annuity depreciation
 Leased assets
 Idle assets
 Intangible assets
 Noncurrent liabilities
 Capital charge
 ROI vs. EVA

 ROI = Profit / investment

 Residual income = income – (capital * capital
charge)
 EVA = Net profit – capital charge
 Return on Investment (ROI) Formula

Income before interest

and taxes (EBIT)

Net operating income

ROI =
Average operating assets

Cash, accounts receivable, inventory,

plant and equipment, and other
productive assets.
 Calculating Residual Income

Residual
income
=
Net
operating -
income
(
Average
operating
assets

Minimum
)
required rate of
return

This computation differs from ROI.

ROI measures net operating income earned relative to
the investment in average operating assets.
Residual income measures net operating income earned
less the minimum required return on average operating
assets.
 Economic Value Added (EVA)
 EVA is a specific type of residual income
calculation that has recently gained popularity.

EVA = After-tax
Operating Income { Weighted-Average
Cost of Capital X( Total
Assets
Current
Liabilities )}

 Weighted average cost of capital equals the after-

tax average cost of all long-term funds in use.

(c) 2012 Pearson Prentice Hall. All rights reserved.

 Economic Value Added

Investment center’s after-tax operating income

– Investment charge
= Economic Value Added

( )
Investment Investment Weighted
center’s – center’s  average
total assets current liabilities cost of capital

(After-tax Market
cost of  value
debt of debt ) (
Cost of
capital
Market
 equity  value
of equity )
Market Market
value  value
of debt of equity
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