RESPONSIBILITY

ACCOUNTING
Responsibility accounting is the collection, summarization,
and reporting of financial information where individual
manager is held accountable for certain costs, revenue, or
assets of the firm. It can also be called profitability accounting
or activity accounting.

Responsibility accounting is apt where top management has

delegated authority to make decisions. The idea behind
responsibility accounting is that each manager’s performance
should be judged by how well he or she manages those items
under his or her control.

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Responsibility Centre

A responsibility centre is a specific unit of an organisation

assigned to a manager who is held responsible for its
operation and resources.

To enhance the application of responsibility accounting in

decision making, it is essential for an organisation to attach a
level of responsibility (decentralised power/s) to different
divisions/departments and designate as either of cost, profit,
revenue or investment centre

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 Cost/ Expenses Centre
◂ Cost or Expense Centres are responsibility centres where the manager
‘has control over the costs’ (other than those of capital nature) owning
to function, for which he/ she is responsible. For example, the paint
department in an automobile firm.
◂ - Cost centre can use both cost control (Standard costing and
budgetary control) and cost reduction (cost management – such as
Target Costing, Kaizen) tools and techniques

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 Revenue Centre
◂ Revenue Centres are the responsibility centres where the manager has
‘control over the generation of revenue from operation’ with no
responsibility for costs. Ex: booking counter of any Airline Company is
revenue centre.
◂ The key measures used to appraise performance are sales variances.

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 Profit Centres

◂ Profit Centres are the responsibility centres where the manager of such a centre or
division has ‘control on both revenue and costs’ (other than those, which are of
capital nature) earned out of and incurred on assets assigned to the division
respectively. To illustrate, the facility of canteen can be considered as the profit
centre. Thus, performance is measured in terms of the difference between the
revenues and costs.

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 Investment Centres

◂ Investment Centres are the responsibility centres where the manager

has responsibility for not just the revenues and costs relating to the
centre, but also the assets that cause these costs and generate these
revenues and the investment decisions relating to disposal and
acquisition of assets. The performance of an investment centre can be
measured by appraising profit/return in relation to investment base of
centre, ROI, RI, and EVA are some prominent financial performance
measures.

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 DIVISIONAL PERFORMANCE
MEASURES
Performance measurement is directly linked to the organisational structure.
If organisation is divisionalised then performance also needs to be measured at the division
level for each division. It is obvious, that to measure the performance of division certain
performance measures or indicators need to be established.
If any organisation opt for divisional structure, then there are varieties of issues, which
need to be addressed while establishing performance measures to determine performance.
These issues are such as inter-dependence of divisions, goal congruence, allocation of costs
of shared services or head office, and internal transfer pricing policy and etc. These factors
affect the divisional performance substantially.

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A good performance measure should–

▪ Provide the reasonable incentive to the divisional

manager to make decisions which are in the best interests
of the overall company (goal congruence).

▪ Only include factors for which the divisional manager can

be held accountable.

▪ Recognise the long-term objectives as well as the short-

term objectives of the organisation.

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FINANCIAL PERFORMANCE
MEASURES

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 Return on Investment (ROI)
◂ DuPont, an American company during the 1920s become the first to
recognise the need to consider the level of investment along with the
income generated through such investment, while appraising the
performance of the investment centre. Since then many organizations
instead of focusing purely on the absolute size of a division’s profits,
have started focus on the ROI of a division.

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“ROI expresses divisional profit as a percentage of the assets
employed in the division. Assets employed can be defined as
total divisional assets, assets controllable by the divisional
manager or net assets.”

 Common Measure
 Ideal for Comparison across corporate divisions for
companies of similar size and in similar sectors
But
 Divisional ROI can be increased by those actions that will
reduce the overall ROI of the company and conversely the
actions that decrease the divisional ROI may make the
company as a whole better off. In other words, evaluating
divisional managers on the basis of ROI may not encourage
goal congruence.

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 Division A Division B
Available Investment Project Rs 20 L Rs 20 L
Controllable Contribution Rs 2 L Rs 1.4 L
Return on the proposed project 10% 7%
Presently the ROI of Divisions 13% 5%
Overall cost of capital is 8%

This is a situation of sub-optimisation. ROI can

therefore lead to a lack of goal congruence

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 RESIDUAL INCOME
◂ Residual income is excess of controllable profit over a predetermined
organisation-wide minimum hurdle rate (cost of capital charge) on the
investment controllable by the divisional manager. So higher the
residual income means better the performance.

◂ If residual income is used to measure the managerial performance of

investment centres, there is a greater probability that managers will
be encouraged, when acting in their own best interests, also to act in
the best interests of the company

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 Division A Division B
Available Investment Project Rs 20 L Rs 20 L
Controllable Contribution Rs 2 L Rs 1.4 L
Cost of capital(8%) Rs 1.6 L Rs 1.6 L
Residual Income Rs 0.40 L (Rs 0.20L)

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Being an absolute measure, the residual income is not capable
to be used as a tool for making the comparison between the
divisional performances of different sizes. It is obvious, that a
large division is more likely to earn a larger residual income
than a small division.

To overcome this deficiency, targeted or budgeted levels of

residual income should be set for each division that is
consistent with asset size and the market conditions of the
divisions.

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 Economic Value Added (EVA)

◂ Joel Stern and Bennett Stewart the founders of New-York based

consulting firm ‘Stern Stewart & Company’ during the 1990s promoted
the EVA. EVA is a performance measurement system that aims to
overcome the limitations of other divisional performance measures
which are based upon accounting profit.

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The major shortcomings of relying upon accounting profit
include–
▪ Profit ignores the cost of equity capital. Companies only
generate wealth when they generate a return in excess of
the return required by providers of capital – both equity and
debt. In financial statements, the calculation of profit does
take into account the cost of debt finance, but ignores the
cost of equity finance.
▪ Profits calculated in accordance with accounting standards
do not truly reflect the wealth that has been created, and
are subject to manipulation by accountants.

An alternate to accounting profit is economic profit and EVA

is a measure of economic profit

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Economic Value Added is a measure of economic profit. Economic
Value Added is calculated as the difference between the Net
Operating Profit After Tax (NOPAT) and the Opportunity Cost of
Invested Capital.

This opportunity cost is determined by multiplying the Weighted

Average Cost of Debt and Equity Capital (WACC) and the amount
of Capital Employed. EVA = NOPAT – WACC × Capital

Where- NOPAT means net operating profit after tax. This profit
figure shows profits before taking out the cost of interest.

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Limitations:

EVA is also, an absolute measure hence not free from

shortcomings like comparison between performances of
enterprises of different size is not possible, and
▪ Largely based upon historical data.

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