MCS 02- Responsibility Centers

Syllabus requirement:

Responsibility Centres - Types of Responsibility Centres - Expense Centres, Profit Centres and Investment Centres - Budgetary Control as a tool for Management Control Systems - Engineered, Discretionary and Committed Costs - Approaches to budgeting w.r.t. Engineered and Discretionary costs - Benchmarking and Total Cost Management

Responsibility Centres

What is a responsibility centre?     

List and explain different types of Responsibility Centres with sketches.

Types of Responsibility Centres

Cost Centre

Cost centres are divisions that add to the cost of the organization, but only indirectly add to the profit of the company. Typical examples include Research and Development, Marketing and Customer service. Companies may choose to classify business units as cost centres, profit centres, or investment centres. There are some significant advantages to classifying simple, straightforward divisions as cost centres, since cost is easy to measure. However, cost centres create incentives for managers to underfund their units in order to benefit themselves, and this underfunding may result in adverse consequences for the company as a whole (reduced sales because of bad customer service experiences, for example). Because the cost centre has a negative impact on profit (at least on the surface) it is a likely target for rollbacks and layoffs when budgets are cut. Operational decisions in a contact centre, for example, are typically driven by cost considerations. Financial investments in new equipment, technology and staff are often difficult to justify to management because indirect profitability is hard to translate to bottom-line figures. Business metrics are sometimes employed to quantify the benefits of a cost centre and relate costs and benefits to those of the organization as a whole. In a contact centre, for example, metrics such as average handle time, service level and cost per call are used in conjunction with other calculations to justify current or improved funding.

           

Profit Centre

A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit.

 A profit centre is a big segment of activity for which both revenues and costs are accumulated: A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre.

 The output of a responsibility centre may either be meant for internal consumption or for outside customers. Accordingly they are classifled as un under.

Natural Profit Centres

 When products or services are sold to outside customers,  revenue is realized and is measured by the price charged from customers. I

Constructed Profit Centre

If on the other hand,  the output is meant for another responsibility centre, then management may decide to treat it as a profit centre.In fact, any responsibility centre can be turned into a profit centre by determining a Transfer price for its outputs. For instance, in case of a process industry, the output of oneprocess may be transferred to another process at a profit at a fairly determined Transfer Price. . Although this exercise does not increase the Company’s assets, it helps in measure  the efficiency of operations of the responsibility centre and thereby helps the management control process.

Investment Centre

In practice, the term investment centre is not widely used. Instead, the term profit centre is used indiscriminately to describe centres that are always assigned responsibility for revenues and expenses, but may or may not be assigned responsibility for the capital investment.

On account of these difficulties, investment centres are generally used only for relatively large units, which have independent divisions, both manufacturing and marketing, for their individual products.

2. Explain the process of evaluation of Responsibility Centre from one stage to another with the help of illustration-cum-experiences of the corporate.

Process of evaluation of Responsibility Centre.

The organization is divided into various responsibility centres. Each responsibility centre is put under the charge of a responsibility manager.

The targets or budgets of each responsibility centre are set in consultation with the manager of responsibility centre, so that he may be able to give full information about his department. The manager of responsibility centre should know as what is expected of him - each centre should have a clear set of goals. The responsibility and authority of each centre should be well defined.

Managers are charged with the items and responsibility, over which they can exercise a significant degree of direct control.

Goals defined for each area of responsibility should be attainable with efficient and effective performance.

The actual performance is communicated to the managers concerned. If it falls short of the standards, the variances are conveyed to the top management. The names of persons responsible for the variances are also conveyed so that responsibility may be fixed.

The purpose of all these steps is to assign responsibility to different individuals so that their performance is improved and costs are controlled. The personal factor in Responsibility Accounting is most important. The management may prepare the best plan or the budget and put up before its staff, but its success depends upon the initiative and the will of the workers to execute it

Example of Responsibility Centre

The Sarva Shiksha Abhiyan emphasizes quality improvement in elementary education for which it deems necessary that resource groups and responsibility centres from national to sub-district levels are identified. These groups would oversee the policy, planning, implementation and monitoring of all quality related interventions. Their major role would be to advise and assist at various levels in curriculum development, pedagogical improvement, teacher education/training and activities related to classroom transaction. In order to facilitate a decentralized mode of education, these groups would need to be constituted at various operational levels, namely - national, state, district and sub district. The following could be involved in the groups:

National level - NCERT, NIEPA, Universities, NGOs, experts and eminent educationists.

State level - SCERT, SIEMAT, Universities, IASEs/CTEs, NGOs, experts and eminent educationists.

District level - DIETs, representatives from DPEP District Resource Group, higher educational institutions, innovative teachers from the districts, NGOs.

Sub-district - BRC/BEO, representatives from CRCs, innovative teachers.

3. Briefly define Discretionary Expense Centre, Engineered Expense Centre, Profit Centre and Investment Centre? How is budget prepared in Discretionary Expenses Centre?

Engineered expense centres:

Engineered expense centre have the following characteristics:

- Their inputs can be measured in monetary terms.

- Their output can be measured in physical terms.

- The optimal dollar amount of input required to produce one unit of output can be established.

Engineered expense centre usually are found in manufacturing operations. Warehousing, distribution, trucking and similar units in the marketing organization also may be engineered expense centre and so many certain responsibility centre within administrative and support department. Examples are accounts receivable account payable and payroll section in the controller department personnel record and cafeteria in the human resource department shareholder record in the corporate secretary department and the company motor pool. Such units perform repetitive task for which standard cost can be developed. In an engineered expense centre the output multiplied by the standard cost of each unit produced represents what the finished product should have cost. When this cost is compared to actual costs, the difference between the two represents the efficiency of the organization unit being measured. We emphasize that engineered expense centres have other important tasks not measured by cast alone. The effectiveness of this aspect of performance should be controlled. For example expenses centre supervisor are responsible for the quality of good and for the volume of production in addition to their responsibility for cost efficiency. Therefore the type and amount of production is prescribed and specific quality standards are set so that manufacturing costs are not minimized at the expense of quality. Moreover manager of engineered expense centre may be responsible for activities such a training that are not related to current production judgment about their performance should include an appraisal of how well they carry out these responsibilities. There are few if any responsibility centre in which all cost items are engineered. Even in highly automated production department the amount of indirect labor and of various services used can vary with management discretion. Thus, the term engineered costs centre refers to responsibility centre in which engineered cost predominate but in does not imply that valid engineering estimates can be made for each and every cost item.

Discretionary expense centre:

The output of discretionary expenses centre cannot be measured in monitory terms. They include administration and support units research and development organization and most marketing activities. The term discretionary does not mean that management judgment is capricious or haphazard. Management has decided on certain policies that should govern the operation of the company. Whether to match exceed or spend less than the marketing effort of its competitor; the level of service that the company provides to the customer. The appropriate amount of spending for R & D, financial planning public relation and many other activities. One company may have a small headquarter staff another company of similar size and in the same industry may have a staff that is 10 times as large. the management of both companies may be concerned that they made the correct decision on staff size but there is no objective way judging which decision was actually better manager are hired and paid to make such decision. After such a drastic change the level of discretionary expenses generally has a similar pattern from one year to the next. The difference between budgeted and actual expense is not a measure of efficiency in a discretionary expense centre it is simply the difference between the budgeted input and the actual input. It in no way measures the value of the output. if actual expense do not exceed the budget amount, the manager has ‘lived within the budget ‘ however ,because by definition the budget does not purport to measure the optimum amount of spending we cannot say that living within the budgeted is efficient performance.

Profit Centre

A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit. Despite the name, a profit centre can exist in nonprofits organizations (though it might not be referred to as such) when a responsibility centre receives revenues for its services. A profit centre is a big segment of activity for which both revenues and costs are accumulated: A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre. The output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case, the revenue is realized when the sales are made. That is, when the output is meant for outsiders, then the revenue will be measured from the price charged from customers. If the output is meant for other responsibility centre, then management takes a decision whether to treat the centre as profit centre or not. In fact, any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. For instance, in case of a process industry, the output of one process may be transferred to another process at a profit by taking into account the market price. Such transfers will give some profit to that responsibility centre. Although such transfers do not increase the Company’s assets, they help in management control process.

Investment Centre

An investment centre goes a step further than a profit centre does. Its success is measured not only by its income but also by relating that income to its invested capital, as in a ratio of income to the value of the capital employed. In practice, the term investment centre is not widely used. Instead, the term profit centre is used indiscriminately to describe centres that are always assigned responsibility for revenues and expenses, but may or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in which inputs are measured in terms of cost / expenses and outputs are measured in terms of revenues and in which assets employed are also measured. A responsibility centre is called an investment centre, when its manager is responsible for costs and revenues as well as for the investment in assets used by his centre. He is responsible for maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre. The investment centre manager has control over revenues, expenses and the amounts invested in the centre’s assets. The manager of an investment centre is required to earn a satisfactory return. Thus, return on investment (ROI) is used as the performance evaluation criterion in an investment centre. He also formulates the credit policy, which has a direct influence on debt collection, and the inventory policy, which determines the investment in inventory. The Vice President (Investments) of a mutual funds company may be in charge of an Investment Centre. In the Investment Centre, the manager in charge is held responsible for the proper utilization of assets. He is expected to earn a satisfactory return on the assets employed in his responsibility centre.

Budget Preparation.

The decision that management make about a discretionary expense budget are different from the decisions that it makes about the budget for an engineered expense centre. For the latter management decides whether the proposed operating budget represent the cost of performing task efficiently for the coming period. management is not so much concerned with the magnitude of the task because this is largely determined by the actions of other responsibility centres, such as the marketing departments ability to generate sales. In formulating the budget for a discretionary expense centre, however management principal task is to decide on the magnitude of the job that should be done. These tasks can be divided generally into two types continuing and special. Continuing task are those that continue from year to year for example financial statement preparation by the controller’s office. Special tasks are one shot project for example developing and installing a profit budgeting system in a newly acquired division. The technique management by objective is often used in preparing the budget for a discretionary expense centre. Management by objective is a formal process in which a budget purposes to accomplish specific tasks and state a mean for measuring whether these tasks have been accomplished. There are two different approach to planning for the discretionary expense centre increment budgeting and zero based review.

Zero Based Budgeting:

Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. No reference is made to the previous level of expenditure. By contrast, in zero-based budgeting, every department function is reviewed comprehensively and all expenditures must be approved, rather than only increases.[1]Zero-based budgeting requires the budget request be justified in complete detail by each division manager starting from the zero-base. The zero-base is indifferent to whether the total budget is increasing or decreasing.

The term "zero-based budgeting" is sometimes used in personal finance to describe the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. It would be more technically correct to refer to this practice as "active-balanced budgeting".

Advantages of Zero-Based Budgeting:

Efficient allocation of resources, as it is based on needs and benefits.

Drives managers to find cost effective ways to improve operations.

Detects inflated budgets.

Municipal planning departments are exempt from this budgeting practice.

Useful for service departments where the output is difficult to identify.

Increases staff motivation by providing greater initiative and responsibility in decision-making.

Increases communication and coordination within the organization.

Identifies and eliminates wasteful and obsolete operations.

Identifies opportunities for outsourcing.

Forces cost centres to identify their mission and their relationship to overall goals.

Disadvantages of Zero-Based Budgeting:

Difficult to define decision units and decision packages, as it is time-consuming and exhaustive.

Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.

Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.

In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.

Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results

Internal Control:

Internal control is defined as a process affected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives.[1] It is a means by which an organization's resources are directed, monitored, and measured. It plays an important role in preventing and detecting fraudand protecting the organization's resources, both physical (e.g., machinery and property) and intangible (e.g., reputation or intellectual property such as trademarks). At the organizational level, internal control objectives relate to the reliability of financial reporting, timely feedback on the achievement of operational or strategic goals, and compliance with laws and regulations. At the specific transaction level, internal control refers to the actions taken to achieve a specific objective (e.g., how to ensure the organization's payments to third parties are for valid services rendered.) Internal control procedures reduce process variation, leading to more predictable outcomes

DESCRIBING INTERNAL CONTROLS:

Internal controls may be described in terms of: a) the objective they pertain to; and b) the nature of the control activity itself.

Objective categorization

Internal control activities are designed to provide reasonable assurance that particular objectives are achieved, or related progress understood. The specific target used to determine whether a control is operating effectively is called the control objective. Control objectives fall under several detailed categories; in financial auditing, they relate to particular financial statement assertions,[5] but broader frameworks are helpful to also capture operational and compliance aspects:

Existence (Validity): Only valid or authorized transactions are processed (i.e., no invalid transactions)

Occurrence (Cutoff): Transactions occurred during the correct period or were processed timely.

Completeness: All transactions are processed that should be (i.e., no omissions)

Valuation: Transactions are calculated using an appropriate methodology or are computationally accurate.

Rights & Obligations: Assets represent the rights of the company, and liabilities its obligations, as of a given date.

Presentation & Disclosure (Classification): Components of financial statements (or other reporting) are properly classified (by type or account) and described.

Reasonableness-transactions or results appear reasonable relative to other data or trends.

Activity categorization

Control activities may also be described by the type or nature of activity. These include (but are not limited to):

Segregation of duties - separating authorization, custody, and record keeping roles to limit risk of fraud or error by one person.

Authorization of transactions - review of particular transactions by an appropriate person.

Retention of records - maintaining documentation to substantiate transactions.

Supervision or monitoring of operations - observation or review of ongoing operational activity.

Physical safeguards - usage of cameras, locks, physical barriers, etc. to protect property.

Analysis of results, periodic and regular operational reviews, metrics, and other key performance indicators (KPIs).

IT Security - usage of passwords, access logs, etc. to ensure access restricted to authorized personnel. S

Meaning:

A responsibility centre in an organization unit that is headed by a manager who is responsible for its activities.  In a sense company is a collection of responsibility centres, each of which is represented by a box on the organization chart.

Nature of responsibility centres

A responsibility centre exists to accomplish  one or more purposes, termed  its objectives. The company as a whole has goals, and senior management has decided on a set of strategies to accomplish these goals. The objectives of responsibility centres are to help implement these strategies. Because the organization is the sum of its responsibility centres,  If each responsibility centre meets its objectives the whole organization should achieve its goals

. A responsibility centre receives  inputs in the form of materials, labour and  a variety of services. Its work with these inputs using  working capital, equipment, and other asset to perform a function.. As a result of this work the responsibility centre produces output which is classified either as goods if they are tangible or as services if they are intangible.

 Every responsibility centre has output, that is, it does something. In a production plant, the outputs are goods. In staff units, such as human resources, transportation, engineering, accounting, and administration, the output s are services. For many responsibility centres, especially staff units, outputs are difficult to measure; nevertheless, they exist.

The products produced by a responsibility centre may be furnished to another responsibility centre or to the outside marketplace. In the first case, the product are inputs to the other responsibility centre in the latter case, they are output s of the whole organization.

Types of Responsibility Centres

There are four types of responsibility centres, classified according to the nature of the monetary inputs and /or output. They are;

1.      Revenue centre

2.      Expense centre,

3.      Profit centre and

4.      Investment centre.

In revenue centre output is measured in monetary terms, in expense centre input is measured in monetary terms, in profit centre both revenue (output) and expense (input) are measured and in investment centre the relationship between profit and investment is measured.

Each and every responsibility centres requires a different type of planning and control system.

Revenue centre:

In a revenue centre output is measured in monetary terms, but no formal attempt is made to relate input to output .Generally, revenue centres are marketing/sales units that do not have authority to set selling prices and do not charged for the cost of the goods they sell.

Actual sales or orders booked are measured against the budgets and quotas, and the manager is held responsible for the expenses incurred directly within the unit.

The primary measurement is revenue in this centre.

Expense centre

Expense centres are responsibility centres whose inputs are measured in monetary terms, but whose outputs are not. There are two general types of expense centres;

1.      Engineered and

2.      Discretionary.

Engineered costs are those for which the right and proper amount can be estimated with reasonable reliability – direct costs.

Discretionary costs are those for which no engineered estimate is feasible – support activities

Engineered Cost Centre

·         The inputs can be measured in monetary terms

·         Their Output can be measured in physical terms

·         The optimum dollar amount of input required to produce one unit of output can be determined.

 Engineered cost centre is basically found in manufacturing operations.  In engineered cost centre output multiplied by the standard cost of each unit gives what  the finished product should have cost.

The engineered cost centre not only measure the cost but it is also responsible for the quality of the products, volume of the production as well as efficiency.

Discretionary expense centre:

The output of discretionary expenses centre cannot be measured in monitory terms.

They include administration and support units (accounting, legal, human resources ) research and development and most marketing activities.

 The term discretionary does not mean that management’s judgment as to optimum cost  is capricious or haphazard. Rather it reflects management’s decision regarding  certain policies: Whether to match, exceed or spend less than the marketing effort of its competitor;  the level of service that the company provides to the customer; the appropriate amount of spending for R & D, financial planning public relation and a host of other activities.

One company may have a small headquarter staff another company of similar size and in the same industry may have a staff that is 10 times as large. the management of both companies may be convinced that they made the correct decision on staff size but there is no objective way of  judging which decision was actually better.

 The difference between budgeted and actual expense is not a measure of efficiency in a discretionary expense centre it is simply the difference between the budgeted input and the actual input. It does not incorporate  the value of the output. If actual expense do not exceed the budget amount, the manager has ‘lived within the budget ‘ however ,because by definition the budget does not purport to predict  the optimum amount of spending, living within the budget does not indicate efficient performance.

Profit Centre

A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit.

 A profit centre is a big segment of activity for which both revenues and costs are accumulated: A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre.

 The output of a responsibility centre may either be meant for internal consumption or for outside customers. Accordingly they are classifled as un under.

Natural Profit Centres

 When products or services are sold to outside customers,  revenue is realized and is measured by the price charged from customers. I

Constructed Profit Centre

If on the other hand,  the output is meant for another responsibility centre, then management may decide to treat it as a profit centre.In fact, any responsibility centre can be turned into a profit centre by determining a Transfer price for its outputs. For instance, in case of a process industry, the output of one process may be transferred to another process at a profit at a fairly determined Transfer Price. . Although this exercise does not increase the Company’s assets, it helps in measure the efficiency of operations of the responsibility centre and thereby helps the management control process.

Investment Centres:

It is a responsibility centre in which inputs are measured in terms of cost / expenses and outputs are measured in terms of revenues and in which assets employed are also measured.

An investment centre goes a step further than a profit centre does. Its success is measured not only by its profits alone. The relationship between profits and the assets that are used to generate those profits are also measured;

 A responsibility centre is called an investment centre, when its manager is responsible for costs and revenues as well as for the investment in assets used by his centre. He is responsible for maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre.

 The investment centre manager has control over revenues, expenses and the amounts invested in the centre’s assets. For instance, he  formulates the credit policy, which has a direct influence on debt collection, and the inventory policy, which determines the investment in inventory.

 The manager of an investment centre is required to earn a satisfactory return. Two of the performance evaluation measures  employed are i) Return on Investments and ii) Economic Value Added (EVA)  

Q.        What are the differences between Engineered Expense Centre and  Discretionary Expense centre ? Give your answer with respect to the following control characteristics:

a)      Budget Preparation

b)     Cost Variability

c)      Typical Financial Controls

d)     Measurement of performance

Ans:

Budget Preparation:

For the Engineered Expense Centre the management seeks to know whether the proposed operating budget represents the unit cost of performing itsn task efficiently. Its volume is largely determined by the actions of other responsibility centres.- for example the marketing departments ability to generate sales.

In contrast,In a Discretionary Expense Centre, the  management formulates the budget by determining the magnitude of the job that needs to be done. The work done here falls into two general categories:

1.      Continuing: Done consistently from year to year, such as preparation of financial statements.

2.      Special: A one shot project – developing and installing a system in new acquired division.

The technique used in this budgeting is management by objectives, a formal process by which  the budgetee  proposes to accomplish specific jobs and suggests the measurements to be used in performance evaluation. The Managers are thereby  involved in the planning process itself, and are thus committed.

The planning function  of the discretionary centre is carried out in one of the two ways:

1.       Incremental budgeting and

2.       Zero-base.

In the Incremental budgeting, the discretionary expense centre’s current level of expenditure is taken as a starting point. This amount is adjusted for inflation, changes in the workload of job. Incremental budgeting has two drawbacks: first, discretionary expense centre’s current expenses are taken as it is and not re-examined during the budget preparation process. From the current level the managers always want to increase the services so they will demand extra budget every time.

Zero-base review: An alternative budgeting approach is to make a thorough analysis of each discretionary expense centre on a rolling basis, so that all are reviewed once and then the budgets are finalized. In contrast with incremental budgeting this review starts from scratch so the resources actually required are only given to the activity.

Cost Variability:

 Unlike the engineered cost which are strongly affected by short- run volume changes, costs in discretionary centres, are comparatively insulated from such short term fluctuations. This stems from the fact that personnel and personnel related costs are by far, the largest expense items in a discretionary cost centre. Hiring and training personnel for short term needs is expensive, and temporary layoffs hurt morale

Type of financial control:

In case of engineered cost centre the objective is to become cost competitive by setting a standard and measuring actual cost against that standard. While, in discretionary cost centre, the control of cost  occurs at the planning phase itself.- before incurring the cost.

Measurement of Performance:

The Financial Performance report is a means of evaluating the efficiency of the manager in the case of an Engineered expense centre, while it is not for a discretionary cost centre. In a

discretionary cost centre the manager has to obtain the desired output. Spending an amount that is “ON Budget” to do this is satisfactory; Spending more than that a matter of concern; and spending less may indicate that the planned work is not being done. Control in Discretionary cost centres is achieved through Nonfinancial performance measures ,such as the opinion of the users.

MCS in Administrative & Support Centres

Administrative centres include senior management and business unit management, along with the managers of supporting staff units. Support centre units that provide services to other responsibility centres.

Control Problems:

·         Difficulty in measuring output

·         Lack of goal congruence

·         Budget Preparation

 MCS in Research and Development Centre:

Control Problems:

·         Difficulty in relating results to inputs

·         Lack of goal congruence

The R&D Range: the activities conducted by R&D has long range, as it starts from basic research on one extreme and product testing at the other range.

The R&D Program: there is no scientific way to determine the optimum size of an R&D budget.

Program list budget plus the blanket allowance for unplanned work.

Measurement of Performance

MCS in Marketing Centre:

Generally, in all the companies two different types of activities are grouped under the heading of marketing that is logistics activities and marketing activities.

Logistics activities: logistics activities are those involved in moving goods from the company to its customers and collecting the the amounts due form customers in return.

Marketing activities are those undertaken to obtain orders for company products. These activities include test marketing, training, supervision of sales force, advertising, sales promotion.

Q.        What do you understand by Goal Congruence? What are the informal factors that influence goal congruence?

Ans: Every individual working in an organization has got his own motive to do the work. Individuals act in their own interest, based on their own motivations. And it is always not necessarily consistent with the Co’s goal. The central purpose of a management control system, is to ensure, as far as possible, a high level of what is called “Goal Congruence”. In a goal congruent process, the actions people are led to take in accordance with their perceived self-interest are also in the best interest of the organization.  i.e. Goal congruence ensures that the action of manager taken in their best interest is also in the best interest of the organization.

Goal congruence is This term is used when the same goals are shared by top managers and their subordinates. The system can achieve its goal more effectively and perform better when organizational goals can be well aligned with the personal and group goals of subordinates and superiors.

The goals of the company should be the same as the goals of the individual business segments. Corporate goals can be communicated by budgets, organization charts, and job descriptions.

 Individuals work in different hierarchies and handle different responsibilities & may have different goals. But they must come together as far as Company’s Goal is concerned (their actions must speak the Company’s language.)

. This is one of the many criteria used to judge the performance of an accounting system

Goal Congruence

Example 1– The HR manager has devised a HR training program to enhance the skills of its sales personnel, with an objective to enhance their productivity. But if company is in strategic need of attaining a certain sales volume in a given quarter, it cannot do so on account of non availability of personnel.

Example 2– The marketing department has planned an impressive advertising campaign, which promises good returns, But say due to cash crunch Company’s current financial position may not let to lose the strings

Example 3 – Production Manager may get a good applause for reducing cycle time; But at what cost? Building up the high inventory i.e. higher investment in current assets. While doing so he just overlooked the financial interest of the company. • After completing the given activity in more efficient manner the concerned manager scores the point/s on his score card. • Whether his actions are leading to scoring of points on the organization’s score card too? if it is so then only one can say the organization is marching towards a common goal.

Informal factors that influence goal congruence:

Informal Factors –

External factors – set of attitudes of the society, work ethics of the society

Internal factors – (Factors within the organization)

• Culture-Common beliefs, shared values, norms of behavior & assumptions

• Implicitly accepted and explicitly built into.

• Mgt. Style – Informal/Formal

• The Communication Channels

• Perception and Communication – e.g. Budget (meaning) strict profit.

Q.        Organizations with Business Divisions (Profit Centre) format have observed that Divisional Controllers experience divided loyalty in carrying out their functions, causing a possible dysfunction. How could such a situation be resolved? Define role of controller which suits your suggestion.

Control- Paradigm shift:

To the extent the decision are decentralized top management may lose some control. Relying on control reports is not as effective as personal knowledge of an operation. With profit centre, top management must change its approach to control. Instead of personal direction senior management must rely to a considerable extent on management control reports.

Competition:

Units that were once cooperating as functional units may now compete with one another disadvantageously. An increase in one manager’s profit may decrease those of another. This decrease in cooperation may manifest itself in a manager unwillingness to refer sales lead to another business unit, even though that unit is better qualified to follow up on the lead. Or in taking production decision that have undesirable cost consequence on other units or in the hoarding of personnel or equipment that from the overall company standpoint would be better off used in another units.

Short Term Emphasis:           

There may be too much emphasis on short run profits at the expense of long run profitability. In the desire to report high current profits, the profit centre manager may skip on R&D, training, maintenance. This tendency is especially prevalent when the turnover of profit centre managers is relatively high. In these circumstances, manager may have good reason to believe that their action may not affect profitability until after they have moved to other job.

Limited Goal Conguence:

There is no complete satisfactory system for ensuring that each profit centre by optimizing its own profit , will optimize company profits. Perfect Goal Congruence does not exist. An adequate control system will at least do not encourage individual Business units to act against the best interest of the organization.

Competency dilution:

If headquarter management is more capable or has better information then the average profit centre manager the quality of some of the decision may be reduced.

Duplication of work:

Divisionalization ma   y cause additional cost because it may require additional management staff personnel and recordkeeping and may lead to redundant at each profit centre.

Trade off between business unit autonomy and corporate constraint:

Business units are usually set up at profit centres. Business unit managers tend to control product development, manufacturing, and marketing resources. They are in a position to influence revenue and cost and as such can be held accountable for the bottom line. To realize fully the advantage of the profit centre concept the business unit manger would have to be as autonomous as the president of the independent company.

 As a practical matter however such autonomy is not feasible. If a company were divided into completely independent units the organization would be giving up the advantage of size and synergism.

Consequently business unit structure represents trade off between business unit autonomy and corporate constraint. The effectiveness of a business units organization is largely dependent on how well these trade off are made.

Evaluation of Profit Centres:

 The performance of a profit centre is appraised by comparing actual results with budgeting amounts. In addition, data on competitors and the industry provide a good cross check on the appropriate of the budget. Data for individual companies are available from the securities and exchange commission. For key business ratios; standard & poor computer services, Inc; Robert Morris associates annual statement studies; and annual survey published in fortune, business week, and Forbes. Trade associations publish data for the companies in their industries.

Revenue Sharings:

Issues related to common revenues may need to be considered. There are some situations in which two or more profit centres participate in the sales effort that results in a sale; ideally, each should be given appropriate credit for its part in this transaction. Many companies have not given much attention to the solution of these common revenue problems. They take the position that the identification of price responsibility for revenue generation is too complicated to be practical and that sale personnel must recognize they are working not only for their own profit centre but also for the overall good of the company. They for example, may credit the business unit that takes an order for a product handled by the another unit with the equivalent of a brokerage commission or a finder fee. In the case of a bank the branch performing a service may be given explicit credit for that service even though the customer account is maintained in another branch.

Role of controller

• It should publish procedure and forms for the preparation of the budget.

• It should provide assistance to budgetees in the preparation of their budget.

• It should administer the process of making budget revision during the year.

• It should coordinate the work of budget departments in lower echelons

• It should analyze reported performance against budget, interprets the result, and prepares summary report for senior management.

Q. Budget as a tool of  Management Control system - Discuss

Ans.     Many different definitions surround the idea of management control. Common in all these definitions is the theme  of  Goal Achievement.

Different experts on the subject, however emphasize different aspects of MCS that are reflected in the purposes of Budgetary control systems.

According to Maciariello  management control is concerned with coordination, resource allocation, motivation, and performance measurement. Marciariello  & Kirby also laid emphasis on communication structures that facilitates the processing of information for the purpose of assisting managers in coordinating  the parts  and attaining the purpose of the organization. They also argued that since MCs is about design of the management systems used to steer an organization towards its purpose, it includes aspects of Planning, organizing and leading functions of Management.

Anthony’s definition of management control as ‘the process by which managers influence other members of the organization to implement the organisation’s strategies” on the other hand, stresses the motivational aspect. So also the cybernetic school stressed  feedback and measurement.

Preparation of an operating budget has the following  principal purposes.

Establishing Objectives

The long term strategic plan helps the managers in preparation of the budgets which are essentially short term proposals. Budget preparation also provide an opportunity to fine tune strategic plans in the light of current situation. This could be viewed as the Planning &  leading function of management.

Coordination of the several Parts

Every responsibility centre manager participates in the budget preparation process.

Every manager’s individual planning  come together here and the inconsistencies may shown up. Thus, with the help of this group work the inconsistencies are identified and resolved.

 Responsibility Distribution

The approved budget should make clear what each manager is responsible for and with the budgets allocated to different departments. This could be viewed as the organizing function of Management Control Systems as argued by  Marciariello  & Kirby

Resource allocation

Budget aims to secure that right amount of resources are distributed based on organizational priorities and that they are effectively used.

Performance evaluation

Commitment is obtained from each manager on the proposals implied in the budget and the actual performance is judged against the budgeted standard.

Communication ( & Feedback)

Budget creates a general awareness of organizational goals and facilitates the understanding of  the big picture. Personnel can see  how their  work is contributing to the organization as a whole and not their unit alone.

Similarly the reporting of variances and the prompt analysis  provides a feedback mechanism, on a continuous basis, to monitor the state of the firm.

Motivation (Inciting)

The budget if realistic creates a benchmark and thus incites the employees to reach that level.

Thus we see that the function of the budget exactly match the purposes of Management Control System. Budget in fact is one of the more important tools, along with Standard costing, Ratio Analysis etc.

Management Control Systems – Multi-disciplinary aspect

 The practice of management control and the design of management control systems draws upon a number of academic disciplines. Management control involves extensive measurement and it is therefore related to and requires contributions from accounting especially management accounting. Second, it involves resource allocation decisions and is therefore related to and requires contribution from economics especially managerial economics. Third, it involves communication, and motivation which means it is related to and must draw contributions from social psychology especially organizational behavior (see Exhibit#1).[7]

Q:2) Every SBU is a profit centre but every profit centre is not a SBU? What are the conditions that should be fulfil for an organization unit to be converted into a profit centre? What are the different ways to measure the performance of profit centre? Discuss their relevant merits and demerits.

Ans: Conditions for an organization to be converted into a profit centre: Many management decisions involve proposals to increase expenses with the expectation of an even greater increase in sales revenue. Such decisions are said to involve expense/revenue trade-offs. Additional advertising expense is an example. Before it is safe to delegate such a trade-off decision to a lower-level manager, two conditions should exist.

• The manager should have access to the relevant information needed for making such a decision.

• There should be some way to measure the effectiveness of the trade-offs the manager has made.

A major step in creating profit centres is to determine the lowest point in an organization where these two conditions prevail. All responsibility centres fit into a continuum ranging from those that clearly should be profit centres to those that clearly should not. Management must decide whether the advantages of giving profit responsibility offset the disadvantages, which are discussed below. As with all management control system design choices, there is no clear line of demarcation.

 Ways to Measure Performance:

There are two types of profitability measurements used in evaluating a profit centre,  just as there are in evaluating an organization as a whole. First, there is the measure of management performance, which focuses on how well the manager is doing. This measure is used for planning, coordinating, and controlling the profit centre's day-to-day activities and as a device for providing the proper motivation for its manager.

Second, there is the measure of economic performance, which focuses on how well the profit centre is doing as an economic entity. The messages conveyed by these two measures may be quite different from each other. For example, the management performance report for a branch store may show that the store's manager is doing an excellent job under the circumstances, while the economic performance report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed. .

The necessary information for both purposes usually cannot be obtained from a single set of data. Because the management report is used frequently, while the economic report is prepared only on those occasions when economic decisions must be made, considerations relating to management performance measurement have first priority in systems design-that is, the system should be designed to measure management performance routinely, with economic information being derived from these performance reports as well as from other sources.

 Types of Profitability Measures

A profit centre's economic performance is always measured by net income (i.e., the income remaining after all costs, including a fair share of the corporate overhead, have been allocated to the profit centre). The performance of the profit centre manager, however, may be evaluated by five different measures of profitability: (1) contribution margin, (2) direct profit, (3) controllable profit, (4) income before income taxes, or (5) net income

(1) Contribution Margin:

Contribution margin reflects the spread between revenue and variable expenses. The principal argument in favor of using it to measure the performance of profit centre managers is that since fixed expenses are beyond their control, managers should focus their attention on maximizing contribution. The problem with this argument is that its premises are inaccurate; in fact, almost all fixed expenses are at least partially controllable by the manager, and some are entirely controllable. Many expense items are discretionary; that is, they can be changed at the discretion of the profit centre manager. Presumably, senior management wants the profit centre to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. A focus on the contribution margin tends to direct attention away from this responsibility. Further, even if an expense, such as administrative salaries, cannot be changed in the short run, the profit centre manager is still responsible for controlling employees' efficiency and productivity.

(2) Direct Profit:

This measure reflects a profit centre's contribution to the general overhead and profit of the corporation. It incorporates all expenses either incurred by or directly traceable to the profit centre, regardless of whether or not these items are within the profit centre manager's control. Expenses incurred at headquarters, however, are not included in this calculation. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs.

(3) Controllable Profit:

Headquarters expenses can be divided into two categories: controllable and non controllable. The former category includes expenses that are controllable, at least to a degree, by the business unit manager-information technology services, for example. If these costs are included in the measurement system, profit will be what remains after the deduction of all expenses that may be influenced by the profit centre manager. A major disadvantage of this measure is that because it excludes non controllable headquarters expenses it cannot be directly compared with either published data or trade association data reporting the profits of other companies in the industry.

(4) Income before Taxes:

In this measure, all corporate overhead is allocated to profit centres based on the relative amount of expense each profit centre incurs. There are two arguments against such allocations. First, since the costs incurred by corporate staff departments such as finance, accounting, and human resource management are not controllable by profit centre managers, these managers should not be held accountable for them. Second, it may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit centre.

There are, however, three arguments in favor of incorporating a portion of corporate overhead into the profit centres' performance reports. First, corporate service units have a tendency to increase their power base and to enhance their own excellence without regard to their effect on the company as a whole. Allocating corporate overhead costs to profit centres increases the likelihood that profit centre manager§ will question these costs, thus serving to keep head office spending in check. (Some companies have actually been known to sell their corporate jets because of complaints from profit centre managers about the cost of these expensive items.) Second, the performance of each profit centre will become more realistic and more readily comparable to the performance of competitors who pay for similar services. Finally, when managers know that their respective centres will not show a profit unless all-costs, including the allocated share of corporate overhead, are recovered, they are motivated to make optimum long-term marketing decisions as to pricing, product mix, and so forth, that will ultimately benefit (and even ensure the viability of) the company as a whole.

If profit centres are to be charged for a portion of corporate overhead, this item should be calculated on the basis of budgeted, rather than actual, costs, in which case the "budget" and "actual" columns in the profit centre's performance report will show identical amounts for this particular item. This ensures that profit centre managers will not complain about either the arbitrariness of the allocation or their lack of control over these costs, since their performance reports will show no variance in the overhead allocation. Instead, such variances would appear in the reports of the responsibility centre that actually incurred these costs. .

(5) Net Income:

Here, companies measure the performance of domestic profit centres according to the bottom line, the amount of net income after income tax. There are two principal arguments against using this measure: (1) after tax income is often a constant percentage of the pretax income, in which case there would be no advantage in incorporating income taxes, and (2) since many of the decisions that affect income taxes are made at headquarters, it is not appropriate to judge profit centre managers on the consequences of these decisions. There are situations, however, in which the effective income tax rate does vary among profit centres. For example, foreign subsidiaries or business units with foreign operations may have different effective income tax rates. In other cases, profit centres may influence income taxes through their installment credit policies, their decisions on acquiring or disposing of equipment, and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. In these situations, it may be desirable to allocate income tax expenses to profit centres not only to measure their economic profitability but also to motivate managers to minimize tax liability.

Merits:

The quality of decisions may improve because they are being made by managers closest to the point of decision.

The speed of operating decisions may be increased since they do not have to be referred to corporate headquarters. . Headquarters management, relieved of day-to-day decision making, can concentrate on broader issues.

Managers, subject to fewer corporate restraints, are freer to use their imagination and initiative.Because profit centres are similar to independent companies, they provide an excellent training ground for general management. Their managers gain experience in managing all functional areas, and upper management gains the opportunity to evaluate their potential for higher-level jobs.

Profit consciousness is enhanced since managers who are responsible' for profits will constantly seek ways to increase them. (A manager responsible for marketing activities, for example, will tend to authorize promotion expenditures that increase sales, whereas a manager responsible for profits will be motivated to make promotion expenditures that increase profits.).

Profit centres provide top management with ready-made information on the profitability of the company's individual components. . Because their output is so readily measured, profit centres are particularly responsive to pressures to improve their competitive performance.

Demerits:

• 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.

• If headquarters management is more capable or better informed than the average profit centre manager, the quality of decisions made at the unit level may be reduced.

• Friction may increase because of arguments over the appropriate transfer price, the assignment of common costs, and the credit for revenues that were formerly generated jointly by two or more business units working together.

• Organization units that once cooperated as functional units may now be in competition with one another. An increase in profits for one manager may mean a decrease for another. In such situations, a manager may fail to refer sales leads to another business unit better qualified to pursue them; may hoard personnel or equipment that, from the overall company standpoint, would be better off used in another unit; or may make production decisions that have undesirable cost consequences for other units.

• Divisionalization may impose additional costs because of the additional management, staff personnel, and record keeping required, and may lead to task redundancies at each profit centre.