About Me

• Prof. Mahesh Halale B.Sc. M.B.A. M.C.A.

• Worked with MSFC from 1985 to 2003
• Working with
Vishwakarma Institute of Management since 2003 as an
Assistant Professor (Approved by UoP)
Written books on
• Management Control Systems – Everest Pune
• Management Information System – HPH Mumbai
• Every year conduct a days workshop on Case Studies
in MIS and MCS for all MBA students
• Completed about 50 project finance consultancy tasks
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10/17/08 hmahesh45@yahoo.com; VIM Pune 1
 Agenda
Topic – Responsibility Centers
3. Revenue Center
4. Cost Center
5. Profit Center
6. Investment Center
Concept
Issues
Performance Measures
Examples
Advantages and Disadvantages
10/17/08 hmahesh45@yahoo.com; VIM Pune 2
 Responsibility Center
Responsibility Center
-
Responsibility center is an entity, held accountable
for an activity/function under consideration, that
becomes its objective/goal
Organization can be looked upon as collection of
responsibility centers.
Each RC consumes certain amount of resources
“INPUTS” and produces certain results “OUTPUT”
Best option to assess the performance of RC starts
with establishing relationship among INPUT and
OUTPUT and then applying it scrupulously

10/17/08 hmahesh45@yahoo.com; VIM Pune 3

 Responsibility Centers -
1. Revenue Center -
Prime concern of the REVENUE CENTER –
“TOPLINE”
e.g. Marketing center
Inputs Output
(Money directly RC’s (Sales Generated
spent on achieving TASK in money terms)
sales i.e. Mktg. Exp.)
Generate Sales

• RC has no authority to decide price.

• RC is charged with cost of Marketing and not with cost of
goods produced
• No formal relationship possible between I & O
• Performance Measure for the RC can be Revenue Budgets.
10/17/08 hmahesh45@yahoo.com; VIM Pune 4
 Revenue Center - Issues
Decision Rights –
Promotion Mix –
Performance Measures –
Maximize total sales for a given promotion budget
Actual sales in comparison with budgeted sales
Typically used when –
RC manager has thorough knowledge about
market
Promotion plays significant role in generating
sales
RC manager can establish optimal promotion mix
He can set optimal quantity and appropriate
rewards
10/17/08 hmahesh45@yahoo.com; VIM Pune 5
 2. Cost/Expenses Center:
Engineered Expenses V/s Discretionary Expenses
e.g. Manufacturing a e.g. R&D Project
product
Can be established Can not be established
scientifically scientifically
Cost varies with even Costs varies with bigger
small fluctuations in volume changes
volume
Control is easier. Control Review of task is the only
starts with planning & control measure for cost
ends with finished task. control. Control is
Financial Performance exercised during planning
measure suffice the stage itself, by way of
purpose of evaluation. establishment of budget
Financial as well as non
financial Performance
10/17/08 measure
hmahesh45@yahoo.com; VIM Pune need to be 6
 Cost Center
Inputs RC’s Output
(Money spent on (Physical units
TASK
production) Produced)

Decision Rights –
Input Mix – Labor, Material, Supplies
Performance Measures –
Minimize total cost for a fixed output
Maximize output for a given “cost budget”
Typically used when –
RC manager can measure output & quality of output
knows cost functions, optimal input mix
can set optimal quantity and appropriate rewards
10/17/08 hmahesh45@yahoo.com; VIM Pune 7
 2. Expenses Center –
2.1)Engineered Exp. Center e.g. Production
Department
Engineered expenses are those expenses which
are arrived at with reasonable reliability.e.g.
Material cost , labor cost.

Inputs RC’s Output

(Money spent on (Physical units
TASK
production) Produced)

• Performance Measure for the RC is std.cost: -

Std Cost of doing actual activity = Std. cost of unit activity *
Quantum of Actual activity
• One can establish relationship between I & O , hence
performance measurement is relatively easy
10/17/08 hmahesh45@yahoo.com; VIM Pune 8
 2. Expenses Center –
2.2) Discretionary Expenses Center -e.g. R&D,
Advt. Dept, a Movie Project
Discretionary expenses are those expenses
which can not be established with perfect accuracy

Inputs RC’s Output

(Money spent on (Product
TASK
R & D) Development)

• Difficult to estimate Input (hence called MANAGED

costs)
• Output can not be measured in monetary terms.
• Difficult to establish optimal relationship between I
and O
• Performance Measure for the RC is Budgeted Input and
Actual Input.

10/17/08 hmahesh45@yahoo.com; VIM Pune 9

Control Characteristics of Discretionary Cost Center
• Heavy Reliance on Budgets
• For on going activity its bit easier than a new project
• Budgeting technique used for controlling could be –
• Incremental Budgeting
• Zero Base Budgeting
• Difficult to control short term fluctuations, as Discretionary
costs usually remain unaffected in short term unlike
engineered costs.

10/17/08 hmahesh45@yahoo.com; VIM Pune 10

 Discretionary Expenses Center - Examples

i) Administrative and Support Centers-

Senior management units at corporate level e.g.
Legal, Planning , IT , Audit Departments
• Goals may differ and hence performance
ii) Research and Development Centers –
• The input and output may span over
different and uneven time periods.
iii) Marketing Center -

10/17/08 hmahesh45@yahoo.com; VIM Pune 11

 3. Profit Center -
Profit is most comprehensive measure of performance
Function/Activity having highest influence on Bottom
Line suits best for Profit Center.
Can be a Business Division or any of the functional unit
Demands highest freedom/autonomy than any other
RCs’

Output
Inputs RC’s (Money-profit
(Money spent for
TASK Earned out of sales)
earning profits)

Relationship can be established

10/17/08 hmahesh45@yahoo.com; VIM Pune 12

 Profit Center
Decision Rights –
Input Mix – Labor, Material, Supplies
Product Mix
Selling Price
Performance Measures –
Actual Profits
Actual Profit in comparison with budgeted profits
Typically used when –
RC manager has knowledge about correct
price/quantity
RC manager has knowledge to select optimal
product mix
CANDIDATES FOR PROFIT CENTER ……………
10/17/08 hmahesh45@yahoo.com; VIM Pune 13
 3. Business Unit as Profit Center
Business Units In a Decentralized Company
Best suited as Profit Center
Marketing Center as Profit Center–
– Marketing Function having highest influence on
Bottom Line, e.g. Colgate, Coca-Cola, Wipro- Bath Soaps
division, Dabur-Cosmetics division etc.
– When centralized control is infeasible e.g. Foreign
Marketing Center e.g. IBM, Microsoft, Honda India
To Convert Marketing Division into Profit Center
Charge cost of production to revenue center
Grant of maximum autonomy to the unit
Delegate sufficient authority
Treat the unit as a mini company

10/17/08 hmahesh45@yahoo.com; VIM Pune 14

 3. Functional Unit as Profit Center
Manufacturing Division –
– When Cost of production having highest impact on
Bottom Line and
– When Marketing Function is relatively insignificant
e.g. Nirama Detergent
To convert a Production Division in to Profit Center
Credit selling price less marketing expenses to production
division
3. Service and Support Center –
e.g. Maintenance, Customer Service, Transportation,
Engineering Design Divisions
Given greater autonomy, helps them to cut cost and make its
operations more efficient

10/17/08 hmahesh45@yahoo.com; VIM Pune 15

 3. Profit Center – Performance Measures
Performance Measure Justification
• Revenue
Less VC of Mfg. & Marketing
1. Contribution Margin Fixed Cost is beyond control of PC

Less Fixed Expenses

2. Direct Profit
Less Controllable Corporate Expenses
3. Controllable Profit
Less Other Corporate Allocations
4. Net Profit Before taxes
Less Income tax
5. Net Profit
All Expenses incurred at the behest of PC
Some HQ expenses exclusively incurred
for given PC at HQ – IT services
Common unavoidable expenses
incurred to run a company ; e.g.
All administration, financing and tax
planning activities are carried at HQ
In some cases RC do have
impact on tax liability of the company -
Tax Heavens

10/17/08 hmahesh45@yahoo.com; VIM Pune 16

 3. Profit Center - Advantages
• Improves quality of decision – RC Mgr are closest to the point of
decision
• Improves speed of decision – less intervention by HQ
• HQ is relieved of day-to-day decisions making process –
can concentrate on more strategic
decisions
• Provides training ground for general mgt. as RC’s acts as
mini Cos’. profit consciousness with every expense made.
• Enhances
(mktg. mgr. will tend to authorize
promotional expenditure which increases
the sales).
• Provides best performance indicators of Co’s individual
component.
• Since output is clear cut evident, it evokes competition.
• Ensures better and safer delegation of authority.
• Ensures better motivation and evokes commitment.

10/17/08 hmahesh45@yahoo.com; VIM Pune 17

3. Profit Center – Dis-Advantages
• Caliber of RC mgr. may hamper the decision.

• Incase of more integrated company there may be

problems of cost sharing, transfer pricing, sharing credit
for revenue.
• Divisionalisation may impose additional cost of
admn/support units.
• Functional set up may not have competent of GM to manage
RC.
• Functional units once cooperated may now be in
competition with one another- (as profit of one is loss
to another).
• May encourage short term motive at the expense of Co’s
overall goal.
• Optimization of RC’s profit not necessarily mean
optimization of company’s profits.
• Decentralization makes top mgt. to rely more on MC
reports

10/17/08 hmahesh45@yahoo.com; VIM Pune 18

 Responsibility Centers
4. Investment Centers –
Output
Inputs
(Money/net profit
(Money spent for RC’s
Earned on account
Starting & running TASK of investment)
the business)

• Objective – Make sound investment decision

• It compares Business units profits with assets

employed to earn that profit i.e. efficiency of assets
employed.
• It satisfies both the goals of business organizations
i.e. to earn the profit and
to achieve optimal relationship in profits earned
and assets employed

10/17/08 hmahesh45@yahoo.com; VIM Pune 19

 Investment Center
Decision Rights –
Input Mix – Labor, Material, Supplies
Product Mix
Selling Price
Capital Investment
Performance Measures –
Actual ROI
Actual Residual Income i.e. EVA
Actual ROI & RI in comparison with budgeted ROI & RI
Typically used when –
RC manager has knowledge about correct price/quantity
RC manager has knowledge to select optimal product mix
RC manager has knowledge about investment opportunities
10/17/08 hmahesh45@yahoo.com; VIM Pune 20
 Return on Investment –
Return on Investment-
 Relating the profits of a firm with the
investment made.
 ROI can be computed in many different ways
depending upon the need and relevance.

1. Return on Assets - ROA

2. Return on Capital Employed - ROCE

3. Return on Shareholder’s Equity - ROE

10/17/08 hmahesh45@yahoo.com; VIM Pune 21

 Return on Investment – Return on Assets
Net Profit
1) Return on Assets = --------------- * 100
Assets
ROI terminology would change depending on
what Assets base one takes for computation;
it can be -
 Total Assets,
 Fixed Assets,
 Gross Assets,
 Net Assets,
 Tangible Assets or
 Employed Assets
10/17/08 hmahesh45@yahoo.com; VIM Pune 22
 Return on Investment – Return on Capital Employed

Net Profit
2) Return on Capital Employed = ------------------------- *
100
Capital Employed
 Capital implies the long term
funds
supplied by creditors &
 Alternatively it can be
owners
Net Working Capital + Fixed
Assets

10/17/08 hmahesh45@yahoo.com; VIM Pune 23

 Return on Investment – Return on Shareholders’ Equity

Net Profit
3) Return on Shareholders’ Equity = ---------------- * 100
Equity Capital

Equity includes the preferential capital, however the

ordinary shareholder bears the entire risk.
Net Worth represents the equity capital plus the reserves
and surpluses the portion solely represented by equity
holders’.
Net Profit- Pref. Divi.
Return on Shareholders’ Equity = ------------------- * 100
Net Worth
10/17/08 hmahesh45@yahoo.com; VIM Pune 24
 Responsibility Centers
4. Investment Centers –

Economic Value Added - EVA® (Stern & Stewart)

As lender require certain interest on their money,
owners too expect certain rate of return on their
funds. (taken together both termed as cost of
capital).

Hence no "real" money is made or value is created

until the operating profits exceed the rupee return
required by the owner and the lenders.

 Increase in EVA,  Increase in Market Value of

the firm
10/17/08 hmahesh45@yahoo.com; VIM Pune 25
 Economic Value Added – EVA® (Stern &
Stewart)

• EVA is another of the way to relate profits to assets

employed.
• Economic Value Added = Net Profit – Capital Charge
Capital Charge = Capital Employed * Cost of Capital

• EVA=Net profit – (Cost of Capital * Capital Employed)

• This is nothing but Residual Income which adds to

the value of the firm

10/17/08 hmahesh45@yahoo.com; VIM Pune 26

 Return on Investment V/s
Economic Value Added

1. ROI is a ratio. 1. EVA is Profitability

Simple & easy to measure in money
understand, term. Can not be
Meaningful in used for comparison
absolute sense. with other Business
Being a common Unit or Industries.
denominator of
industries it can used
for comparison.

10/17/08 hmahesh45@yahoo.com; VIM Pune 27

 Return on Investment V/s
Economic Value Added
2. Different ROI % 2. EVA provides an
provides different effective measure
incentives across than ROI. EVA
BUs’ Stresses upon
(e.g. BU having current recovery of cost of
ROI of 30 will be capital. And
discouraged to go for welcomes every
additional investment rupee earned over
giving 25% ROI, even
and above COC.
though the ROI is greater
than Cost of Capital OR
BU mgr can improve its
ROI by just disposing the
assets which give lesser
ROI than current one)
10/17/08 hmahesh45@yahoo.com; VIM Pune 28
 Return on Investment V/s
Economic Value Added

3. ROI does not allow 3. EVA enables to use

different treatment
for different kind of
assets i.e. it treats all
assets/investments
at par.
different rates of
interest for different
types of assets
involving different
risks. e.g. low rate for
inventory investment
whereas higher rate
for fixed investment.

10/17/08 hmahesh45@yahoo.com; VIM Pune 29

 Return on Investment V/s
Economic Value Added

4. It is difficult to EVA has got strong &

define an explicit positive correlation
relationship between with market value of
ROI and Market value the firm.
of the firm. (ROI not
necessarily indicate
the market value of
the firm.)

(shareholders worth maximization may not be suitable measure for RC’s performance evaluation
Because it is consolidated effect of entire company)

10/17/08 hmahesh45@yahoo.com; VIM Pune 30

 Computing EVA for HLL
Calculation of
1999 1998 1997 1996
ROCE
Operation Profit 1,206 956 711 464
- Less
129 101 58 55
Depreciation
- Less Tax Paid 318 286 281 173
- Less Tax shield
5 8 11 17
on interest
Net Optg Profit
less adj Taxes 754 562 361 219
(NOPLAT)
Average Capital
2,118 1,703 1,412 688
Employed

WACC (%) 19 18 19 22

Capital Charge 402.42 306.54 268.28 151

EVA
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hmahesh45@yahoo.com; VIM Pune 92.72 98
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 Thank You….

10/17/08 hmahesh45@yahoo.com; VIM Pune 32