Responsibility Centers:

Revenue & Expense Centers

Chapter 4 1
Responsibility Centers
A responsibility center is an organization unit that is
headed by a manager who is responsible for its
activities
A company is a collection of responsibility centers,
each of which is represented by a box on the
organization chart. These responsibility centers form
hierarchy. At the lowest level are the centers for
sections, work shifts & other small organization units.
Departments or business units comprising several of
these smaller units are higher in the hierarchy.

Chapter 4 2
Responsibility Centers
Nature of Responsibility Centers
A responsibility center exists to accomplish one or more
purposes objectives.
The company as a whole has goals & senior
management decides on a set of strategies to
accomplish these goals.
The objectives of the companys various responsibility
centers are to help implement these strategies.
Every organization is the sum of its responsibility
centers:
if each responsibility center meets its objectives the goals
of organization
g will have been achieved

Chapter 4 3
Responsibility Centers
Nature of Responsibility Centers
Responsibility centers receive inputs materials,
materials
labor and services. Using working capital (e.g.,
inventory, receivables), equipment & other assets, the
responsibility
ibilit center
t performs
f it
its particular
ti l ffunction
ti
with the ultimate objective of transforming its inputs
into outputs tangible & intangible.
In production plan output are goods
In staff units, human resources, transportation, engineering,
accounting & administration, outputs are services.
The
h products
d produced
d dbby a responsibility
b l center may
be furnished either to another responsibility center,
p
where there are inputs or to the outside marketplace.
p
Revenues are the amounts earned from providing these
outputs. Chapter 4 4
Responsibility Centers
Relation between Inputs & Outputs
Management is responsible for ensuring the optimum
relationship between inputs & outputs.
In production department the relationship is
causal & direct where the inputs of raw material
become a physical part of the finished goods.
Control focuses on using the minimum input
necessary to produce the required output according
to the correct specifications & quality standards, at
the time requested & in the quantities desired.

Chapter 4 5
 Responsibility Centers
Relation between Inputs & Outputs
IIn many situations,
it ti i
inputst are nott di
directly
tl related
l t d tto
output.
Advertisingg expense
p is an input
p that is intended to
increase sales revenue. Since revenue is affected by
many factors other than advertising, the relationship
between increased advertising & any subsequent
increase in revenue is rarely demonstrable &
managements decision to increase advertising
expenditures
dit is
i typically
t i ll based
b d on judgment
j d t rather
th th than
data.
Research & development
p relationshipp between inputs
p
& outputs more ambiguous. Value of today R&D effort
may not be known for several years. Chapter 4 6
Responsibility Center

Inputs Outputs
Work
Resources used, Goods or
measured byy services
cost

Capital

Chapter 4 7
Responsibility Centers
Measuring Inputs & Outputs
IInputt can be
b stated
t t d as physical
h i l measurements t hours
h
of labor, quarts of oil, reams of paper & kilowatt hours
of electricity.
In MCS these quantitative amounts are translated in
monetary terms; money is a common denominator that
allows the value of several different resources
combined or compared. The monetary value of a given
input is calculated by multiplying a physical quantity by
a price
i per unit it called
ll d cost;
t thi
this iis th
the way a
responsibility centers input is commonly expressed.
Cost is a monetary measure of the amount of
resources used by a responsibility center.
Chapter 4 8
Responsibility Centers
Inputs are resources used by the responsibility center.
Patients in a hospital or students in a school are not
inputs. Inputs are the resources that the hospital or
school uses to accomplish the objective of treating the
patients or educating the students

It is much easier to measure the cost of inputs than to

calculate the value of outputs Annual revenue
important
p measure of a pprofit oriented organizations
g
output but that figure did not express all the
organization did during that year

Chapter 4 9
 Responsibility Centers
Efficiency & Effectiveness
Efficiency is the ratio of output to input or the amount of
output per unit of input
Responsibility Center A is more efficient than Responsibility
Center B
1. If it uses fewer resources more efficient than Responsibility Center B
but produces the same output
2. If it uses the same amount of resources but pproduces a g
greater output
p

In many responsibility centers, efficiency is measured by

comparing
p g actual costs with some standard of what those
costs should have been at measured output, it has major
flaws:
1. Recorded costs are not precise measures of the resources actually
consumed.
2. The standard is merely an approximation of what ideally should
have happened under the prevailing circumstances. Chapter 4 10
 Responsibility Centers
Effectiveness is determined by the relationship between
a responsibility centers output and its objectives.
The more this output contributes to the objectives, the
more effective the unit.

Both objectives & outputs are difficult to quantify, so

effectiveness tends to be expressed in subjective,
subjective
nonanalytical terms.
Efficiency & effectiveness are not mutuallty exclusive;
every responsibility center ought to be efficient &
effective.
A responsibility center is efficient if it does things right &
it is effective if it does the right things
Chapter 4 11
Responsibility Centers
The Role of Profit
A major objective of any profit oriented organization
is to earn a satisfactory profit.
Profit is an important measure of effectiveness.
Since profit is difference between revenue &
expense it is also a measure of efficiency
expense, efficiency.
Profit measures both effectiveness & efficiency.
When such an overall measures exists,
exists it is
unnecessary to determine the relative importance of
effectiveness versus efficiency.

Chapter 4 12
Responsibility Centers
Types of Responsibility Centers
Four types of responsibility centers, classified
according
g to the nature of the monetaryy inputs
p &
outputs that are measured for control purpose:
1. Revenue centers
2. Expense centers
3. Profit centers
4. Investment centers

Chapter 4 13
 Types
yp of Responsibility
p y Centers
Engineered Optimal relationship Example
Expense Centers can be established

Inputs Outputs
Manufacturing
Work function
(dollar) (physical
)

Discretionary Optimal relationship

Expense Centers cannot be established

I
Inputs
t O
Outputs Research &
Work development
(dollar) (physical function
)

Revenue Centers Inputs not related

to outputs

Inputs Outputs Marketing

Work function
(dollar only for (dollar
costs directly profits) Chapter 4 14

incurred)
Profit Centers Input are related
to outputs

Inputs Outputs
B i
Business unit
it
Work
(dollar (dollar
costs) profits)

Investment Profit are related to

Centers capital employed

Inputs Outputs
Business unit
Work
(dollar (dollar
costs) profits)

Chapter 4 15
Responsibility Centers
Revenue Centers
In a revenue center, output (i.e., revenue) is
measured in monetary terms, but no formal
attempt is made to relate input (i.e.,
(i e expense or
cost) to output.
Revenue centers are marketing / sales units that do
not have
h authority
h to set selling
ll prices & are not
charged for the cost of the goods they market.
Actual sales or orders booked are measured against
budgets or quotas & manager is held accountable for
the expenses incurred directly within the unit, the
primary measurement is revenue

Chapter 4 16
Expense Centers
Expense centers are responsibility centers whose
inputs are measured in monetary terms but whose
output are not.
General types
yp of expense
p centers:
engineered
discretionary
Discretionary costs (managed costs) no such
engineered estimate is feasible. The costs incurred
depend on managements judgment as to the
appropriate
i amount under
d the h circumstances.
i

Chapter 4 17
Expense Centers

Engineered costs are those for which the right

right or
proper amount can be estimated with reasonable
reliability a factorys costs for direct labor, direct
material, components, supplies & utilities.

Engineered
g Expense
p Centers
Characteristics :
Input can be measured in monetary term
Output can be measured in physical terms
Optimum dollar amount of input required to produce
one unit of output can be determined

Chapter 4 18
Expense Centers

Found in manufacturing operations.

operations
Warehousing, distribution, trucking & similar units
within the marketing organization
Administrative & support departments
Accounts receivable, accounts payable & payroll
sections in the controller department
Human resources department
Personnel records
Corporate secretary department
Shareholder records

Chapter 4 19
 Expense Centers
Output multiplied by the standard cost of each unit
produced measures what the finished product should
have cost.
The difference between the theoretical & the actual cost
represents the efficiency of the expense center being
measured
Other important tasks
the quality of products
the volume of production
efficiency.
The type & level of production are prescribed & specific
quality
li standards
d d are set, so that
h manufacturing
f i costs are
not minimized at the expense of quality.
The term engineered expense center refers to
responsibilit centers in which
responsibility hich engineered costs
predominate but it does not imply that valid engineered
estimates can be made for each & every cost itemChapter 4 20
 Expense
p Centers
Discretionary Expense Centers
Administrative & support units accounting,
accounting legal
legal, industrial
relations, public relations, human resources, research &
development operations & most marketing activities.
The output of these centers cannot be measured in monetary
terms.
The term discretionary does not imply that managements
judgment optimum cost is capricious or haphazard.
It reflects managements decisions regarding certain policies:
whether to match or exceed the marketing efforts of competitors
the level of service the company should provide to its customers
the appropriate amounts to spend for R&D
financial planning
public relations
Managements view as to proper level of discretionary costs is
always subject to change especially when new management
takes over Chapter 4 21
Expense Centers

IIn a di
discretionary
ti expense center,
t th the diff
difference b
between
t
budget & actual expense is not a measure of efficiency.
It is simply
p y the difference between the budgeted
g input
p &
the actual input & does not incorporate the value of the
output.
If actual
act al e
expense
pense do not exceed
e ceed the budget
b dget amo
amount,
nt the
manager has lived within the budget, but since, by
definition, the budget does not purport to predict the
optimum
ti amountt off spending,
di li
living
i within
ithi th
the b
budget
d t
does not necessarily indicate efficient performance.

Chapter 4 22
 Expense Centers
General Control Characteristics
Budget Preparation
Management makes budgetary decisions for discretionary
expense centers that differ from those for engineered
expense centers.
Engineered expense centers, decides whether the
proposed operating bbudget
dget represents the unit
nit cost of
performing its task efficiently.
Its volume is not major concern largely determined by
the actions of other responsibility centers the
marketing departments ability to generate sales.
Management formulates the budget for a discretionary
expense center by determining the magnitude of the job
that needs to be done. Chapter 4 23
Expense Centers
Two general categories of the work done by discretionary
expense center continuing & special.
1. Continuing work is done consistently from year to year
the p preparation
p of financial statements byy he
controllers office.
2. Special work is a one-shot project developing &
installing a profit-budgeting
profit budgeting system in a newly acquired
division.
A technique used in preparing a discretionary expense
centers
is management by b objectives,
bj i a formal
f l
process in which a budgetee proposes to accomplish
p
specific jobs
j & suggests
gg the measurement to be used
in performance evaluation
Chapter 4 24
Expense Centers
Two ways to carry out the planning function for
discretionary expense centers
1. Incremental Budgeting
Discretionary expense centers current level of expenses
is taken as a starting point. Adjusted for inflation,
anticipated changes in the workload of continuing job,
special job
Two drawbacks:
a. The discretionary expense centers current level of expenditure is accepted &
not reexamined during the budget preparation process
b. Managers of these centers typically want to increase the level of services & tend
to request additional resources
Most budgeting in discretionary expense centers is
incremental. Time does not permit more through analysis.

Chapter 4 25
 Expense Centers
2. Zero Base Review
To make a thorough analysis of each discretionary
expense center on a rolling schedule, so that all are
reviewed at least once every five years.
years
This intensive review attempts to ascertain, from
scratch, the resources actually required to carry out
each activity within the expense center.
This analysis establishes another new base, at which
point the annual budget review simply attempts to keep
costs reasonably in line with this base until the next
review takes place.

Chapter 4 26
Expense Centers
Basic questions raised during this analysis :
1. Should the function under review be performed at all?
Does it add value from the standpoint of end use
customers?
2. What should the quality level be? Are we doing too
much?
3. Should the function be performed in this way?
4. How much should it cost?

Achieving comparability is a difficult matter, as is

determining a correct relationship between cost &
output in discretionary cost situation.
situation
Chapter 4 27
Expense Centers

Zero-base reviews are time-consuming & likely to be

traumatic for the managers whose operations are being
reviewed

In the later 1980s & 1990s, many companies conducted

zero-base reviews, usually as a reaction to a downturn
in profitability. These efforts were often called
downsizing,
g, rightsizing
g g or restructuring
g or p
process
reengineering.

Chapter 4 28
 Expense
p Centers
Cost Variability
Costs in engineering
g g expense
p centers strongly
gy
affected by short run volume changes
Costs in discretionary expense centers are comparatively
insulated from such short-term fluctuations.
Personnel & personnel-related costs are by far the
largest expense items in most discretionary expense
centers;
ce te s; tthe
eaannual
ual budgets te
tend
d to be a co
constant
sta t
percentage of budgeted sales volume.

Once managers of discretionary expense centers hire

additional personnel or plan for attrition in accordance
with the approved budget, it is uneconomical for them
to adjust the work force for short
short-run
run fluctuations;
hiring & training personnel for short-run needs is
expensive & temporary layoffs hurt morale Chapter 4 29
 Expense Centers
Type of Financial Control
Financial
Fi i l control
t l in
i a discretionary
di ti expense center t iis quite
it
different from that in an engineered expense center.
The objective of engineered expense center is to become
cost competitive by setting a standard & measuring actual
costs against this standard.
Main purpose of a discretionary expense budget is to
control costs by allowing the manager to participate in
the planning, sharing in the discussion of what tasks
should
h ld beb undertaken
d t k & what h t llevell off effort
ff t iis appropriate
i t
for each.
In a discretionary expense center, financial control is
primarily exercised at the planning stage before the costs
are incurred Chapter 4 30
Expense Centers

Measurement of Performance
The primary job of a discretionary expense centers
manager is to obtain the desired output.
Spending
S d an amount that
h is on b
budget
d is
considered satisfactory
Spending
p g more cause for concern
Spending less indicate the planned work is not
being done.
The financial performance report is not a means of
evaluating the efficiency of the manager.

Chapter 4 31
 Expense Centers
If these two types of responsibility centers are not
carefully distinguished, management may erroneously
treat a discretionary expense centers performance
report as an indication of the unit
unitss efficiency
motivating those making spending decisions to expend
less than the budgeted amount lover output
Control over spending can be exercised by requiring
the superiors approval before the budget is overrun

The preceding paragraphs are solely related to

financial control. Total control over discretionary
expense centers is achieved primarily through
nonfinancial performance measures.
Chapter 4 32
Administrative & Support Centers

Administrative centers include senior corporate

management & business unit management, along with
the managers of supporting staff units.
Support centers are units that provide services to
other responsibility centers

Control Problems
1. The problems inherent in measuring output
2
2. The frequent lack of congruence between the goals of
departmental staff & of the company as a whole

Chapter 4 33
 Administrative & Support Centers
1. Difficulty in Measuring Output
Some staff activities payroll accounting so routinized that
their units are engineered expense centers.
In other activities, principal output is advice & service
f
functions
ti th
thatt are virtually
i t ll iimpossible
ibl tto quantify.
tif
Output cannot be measured not possible to set cost standards
against which to measure financial performance.

A budget variance cannot be interpreted as representing either

efficient or inefficient performance. If the finance staff were to
b given an allowance
be ll to d
develop
l an activity-based
b d
management system a comparison of actual cost to budgeted
cost would not indicate whether or not the assignment has been
carried out effectively, regardless of the expense involved.
Chapter 4 34
Administrative & Support Centers
2. Lack of Goal Congruence
Managers of administrative staff offices strive for
functional excellence seem to be congruent with
company goals in fact
fact, much depends on how one
defines excellence.
Although a staff office may want to develop the
id l system,
ideal t program,
g or ffunction
ti , th
the id
ideall may
be too costly relative to the additional profits that
perfection may generate. The perfect legal staff,
will not approve any contract that contains even the
slightest flaw; but the cost of maintaining a staff large
enough to guarantee this level of assurance may
outweigh the potential loss from minor flaws
Chapter 4 35
Administrative & Support Centers

A striving for excellence can lead to empire

building or to safeguarding ones position without
g
regard to the welfare of the company
p y

Two problems :
The difficulty of measuring output
The lack goal congruence
Is directly related to the size & prosperity of the
company

Chapter 4 36
 Administrative & Support Centers
In small & medium sized businesses, senior management
is in close personal contact with staff units & can
determine from personal observation what they are doing
& whether a unit is worth its cost.

In business with low earnings, regardless of size,

discretionary expense are often kept under tight control.

In a large business, senior management cannot possibly

know about, much less evaluate, all staff activities & if
that company is also a profitable one,
one there is temptation
to approve staff requests for constantly increasing
budgets.

Support centers often charge other responsibility centers

for the services that they provide. Chapter 4 37
 Administrative & Support Centers
Budget Preparation
The
Th proposed dbbudget
d ffor an administrative
d i i i or support
center usually consists of a list of expense items, with the
proposed budget being compared with the current years
actuall expenses.
Some companies request a more elaborate presentation,
A section covering the basic costs of the center including
th costs
the t off b
being
i iin b
business
i plus
l th
the costs
t off all
ll
intrinsically necessary activities for which no general
management decisions are required.
A section covering the discretionary activities of the center,
center
including a description of the objectives & the estimated
costs of each.
A section fully explaining all proposed increases in the
budget other than those related to inflation.
Chapter 4 38
 Research & Development Centers
Control Problems
1 difficulty in relating results to inputs
1.
2. lack of goal congruence.

1 Difficulty in Relating Results to Inputs

1.
The results of R&D activities are difficult to measure
quantitatively.
R&D usually has at least a semitangible output in the form
of patents, new products or new processes the
relationship of output to input is difficult to appraise on an
annual basis because the completed
p product
p of an R&D
group may involve several years of effort.
Inputs as stated in an annual budget may be unrelated to
p
outputs.
Even when such a relationship can be established, it may
not be possible to reliably estimate the value of the output
Chapter 4 39
Research & Development Centers
2 Lack of Goal Congruence
2.
The research manager typically wants to build the
best research organization money can buy, even
th
thoughh th
thatt may b
be more expensive
i ththan th
the
company can afford.
Research
esea c people o often
te do not
ot have
ave su
sufficient
ce t
knowledge of (or interest in) the business to
determine the optimum direction of the research
efforts.

Chapter 4 40
 Research & Development
p Centers
The R&D Continuum
Activities conducted by
y R&D organizations
g lie along
ga
continuum, with basic research at one extreme & product
testing at the other.
Basic research has two characteristic :
1. Unplanned
U l d with
ith managementt att bbestt specifying
if i ththe generall area
to be explored
2. There is often a significant time lapse between the initiation of
research & the introduction of a successful new product
p
Because financial control systems have little value in managing
basic research activities, alternative procedures are often
employed. Basic research is included as a lump sum in the
research program & its budget.
In others, no specific allowance is made for basic research
there is an understanding that scientists & engineers can devote
part of their time (perhaps 15%
15%, or one day a week) to exploring
in whatever direction they find most interesting, subject only to
the informal agreement of their supervisor Chapter 4 41
Research & Development
p Centers
R&D Program
No scientific way of determining the optimum size of an
R&D budget.
Many companies use a percentage of average revenues
as a bbase.
The specific percentage applied is determined in part
byy a comparison
p with competitors
p R&D expenditures
p &
in part by the companys own spending history.
The R&D program consists of a list of programs plus a
blanket allowance for unplanned work reviewed
annually by senior management.

Chapter 4 42
Research & Development Centers
This review is conducted by a research committee
consisting
i ti off th
the CEO
CEO, the
th research h di
director
t & th the
production & marketing manager.
This committee makes broad decisions as to which
projects to undertake, which to expand, which to cut
back on & which to discontinue.
These decisions highly subjective within the
esliblished policy limits on total research spending.
The research program is determined not by calculating
th total
the t t l amountt off approvedd projects,
j t b butt rather
th b by
dividing the research pie into what seem to be the
most worthwhile slices.

Chapter 4 43
 Research & Development Centers
Annual Budgets
If a company has decided on a long
long-range
range R&D program &
has implemented this program with a system of project
approval, the preparation of the annual R&D budget is a
fairly simple matter, involving mainly the
calendarisation of the expected expense for the budget
period.
If the budget is in line with the strategic plan approval
is routine primarily serves to assist in cash & personnel
planning.
The annual budget process ensures actual costs will not
exceed budgeted amounts without managements
knowledge.
Significant variances from the budget should be approved
by management before they are incurred
Chapter 4 44
Research & Development
p Centers
Measurement of Performance
At regular
l iintervals,
t l usually
ll monthly
thl or quarterly,
t l mostt
companies compare actual expenses with budgeted
expenses for all responsibility centers & ongoing
projects.

In many companies
companies, management receives two types
of financial report on R&D activities.
Type 1 : Compare the latest forecast of total cost with
the approved
appro ed amo
amount
nt for each active
acti e project
project.
Prepare periodically for the executives who
control research spending to help them
determine whether changes should be made in
the list of approved projects Chapter 4 45
Research & Development Centers
Type 2 : Consist of a comparison between budgeted
expenses & actual expenses in each
responsibility center.
Its main purpose to help research executives
anticipate expenses & make sure that expense
commitments are being met.

Neither type of financial report informs management

as to the effectiveness of the research effort .
Such information is formally provided by progress
reports form a partial basis for managements
judgments about the effectiveness of a given project.
Managements primary tool in evaluating effectiveness
is face to face discussion Chapter 4 46
 Marketing Centers

In many companies
companies, two very different types of
activities are grouped under the heading of marketing,
with different controls
Order filling or logistics activities take place after
an order has been received
Order ggettingg activities the efforts to obtain
orders & take place before an order has been
received.

Chapter 4 47
 Marketing Centers
Logistic Activities
Involved in moving goods from the company to its
customers & collecting the amounts due from customers in
return.
Include transportation to distribution centers,
centers
warehousing, shipping & delivery, billing & related credit
function & the collection of accounts receivable.
The responsibility centers that perform these functions are
fundamentally similar to the expense centers in
manufacturing plants.
Many are engineered expense centers that can be
controlled through imposing standard costs & adjusting
budgets to reflect these costs at different levels of volume
Paperwork involved in filling orders & collecting
receivables is accomplished quickly & at low cost by using
internet Chapter 4 48
 Marketing Centers
Marketing Activities
Those undertaken to obtain orders for company
products. Include test marketing; the establishment,
training & supervision of the sales force; advertising &
sales
l promotion
ti allll off which
hi h h
have characteristics
h t i ti th thatt
present management control problems.

It is possible to measure a marketing organizations

output evaluating the effectiveness of the marketing
effort is much more difficult. Because changes in
factors beyond the marketing departments control
(economic condition & action of competitors) may
invalidate the assumptions on which the sales budgets
were based.
Chapter 4 49
 Marketing
g Centers
Meeting g the budgetary
g y commitment for marketing g
expenses is not a major criterion in the evaluation
process, because the impact of sales volume on profits
tends to overshadow cost performance.
performance
The sales target, not the expense target is the critical
factor.

Chapter 4 50
 Marketing
g Centers
The control techniques applicable to logistics activities are
generallyy not applicable
g pp to order-getting
g g activities. Failure
to appreciate this fact can lead to incorrect decisions.
There is often a reasonably good correlation between sales
volume & the level of sales promotion & advertising
expense. mean thatth t sales
l expense vary as a result lt off
sales volume, but such a conclusion would be erroneous.
Flexible budgets that adjust to change in sales volume
cannot be used to control selling expense incurred before
the sale took place.
Neither should advertising or sales promotion expense
g
budgets be adjusted
j to accommodate short-run changes g in
sales volume.
Many companies budget marketing expense as a
percentage of budgeted sales, but they do so not because
sales volume causes marketing expense
expense, but rather on the
belief that the higher the sales volume, the more the
company can afford to spend on advertising. Chapter 4 51
 Marketing Centers
There are three types of activities within a
marketing
k ti g organization.
g i ti
1. The order filling or logistics activity many of
whose costs are engineered expenses
2. The generation of revenue evaluated by
comparing actual revenue & physical quantities sold
with budgeted revenue & budgeted units.
3. There are order-getting costs discretionary
because no one knows what the optimum amounts
should be

Measurement of efficiency & effectiveness for these

costs is highly subjective
Chapter 4 52