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RESPONSIBILITY ACCOUNTING: Responsibility accounting is an underlying concept of accounting performance measurement systems.

The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts. These parts, or segments are referred to as responsibility centers that include: 1) revenue centers, 2) cost centers, 3) profit centers and 4) investment centers. This approach allows responsibility to be assigned to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such as a division of a company where the manager controls the acquisition and utilization of assets, as well as revenue and costs). Controllability Concept An underlying concept of responsibility accounting is referred to as controllability. Conceptually, a manager should only be held responsible for those aspects of performance that he or she can control. In my view, this concept is rarely, if ever, applied successfully in practice because of the system variation present in all systems. Attempts to apply the controllability concept produce responsibility reports where each layer of management is held responsible for all subordinate management layers as illustrated below.

Advantages and Disadvantages Responsibility accounting has been an accepted part of traditional accounting control systems for many years because it provides an organization with a number of advantages. Perhaps the most compelling argument for the responsibility accounting approach is that it provides a way to manage an organization that would otherwise be unmanageable. In addition, assigning responsibility to lower level managers allows higher level managers to pursue other activities such as long term planning and policy making. It also provides a way to motivate lower level managers and workers. Managers and workers in an individualistic system tend to be motivated by measurements that emphasize their individual performances. However, this emphasis on the performance of individuals and individual segments creates what some critics refer to as the "stovepipe organization." Others have used the term "functional silos" to describe the same idea. Consider 9-6 Exhibit below1. Information flows vertically, rather than horizontally. Individuals in the various segments and functional areas are separated and tend to ignore the interdependencies within the organization. Segment managers and individual workers within segments tend to compete

to optimize their own performance measurements rather than working together to optimize the performance of the system.

Summary and Controversial Question An implicit assumption of responsibility accounting is that separating a company into responsibility centers that are controlled in a top down manner is the way to optimize the system. However, this separation inevitably fails to consider many of the interdependencies within the organization. Ignoring the interdependencies prevents teamwork and creates the need for buffers such as additional inventory, workers, managers and capacity. Of course, a system that prevents teamwork and creates excess is inconsistent with the lean enterprise concepts of just-in-time and the theory of constraints. For this reason, critics of traditional accounting control systems advocate managing the system as a whole to eliminate the need for buffers and excess. They also argue that companies need to develop process oriented learning support systems, not financial results, fear oriented control systems. The information system needs to reveal the company's problems and constraints in a timely manner and at a disaggregated level so that

empowered users can identify how to correct problems, remove constraints and improve the process. According to these critics, accounting control information does not qualify in any of these categories because it is not timely, disaggregated, or user friendly. This harsh criticism of accounting control information leads us to a very important controversial question. Can a company successfully implement just-in-time and other continuous improvement concepts while retaining a traditional responsibility accounting control system? Although the jury is still out on this question, a number of field research studies indicate that accounting based controls are playing a decreasing role in companies that adopt the lean enterprise concepts. In a recent study involving nine companies, each company answered this controversial question in a different way by using a different mix of process oriented versus results oriented learning and control information.2 Since each company is different, a generalized answer to this question for all firms in all situations cannot be provided.
DEFINITION OF RESPONSIBILITY ACCOUNTING:
Collection, summarization, and reporting of financial information about various decision centers (responsibility centers) throughout an organization; also called activity accounting or profitability accounting. It traces costs, revenues, or profits to the individual managers who are primarily responsible for making decisions about the costs, revenues, or profits in question and taking action about them. Responsibility accounting is appropriate 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. RESPONSIBILITY CENTRES: Unit in the organization that has control over costs, revenues, or investment funds. For accounting purposes, responsibility centers are classified as Cost Centers, Revenue Centers, Profit Centers, and Investment Centers. A well-designed responsibility accounting system should clearly define responsibility centers in order to collect and report revenue and cost information by areas of responsibility.

Planning & control are essential for achieving good results in any business. Firstly, a budget is prepared and, secondly, actual results are compared with budgeted ones. Any difference is made responsibility of the key individuals who were involved in (i) setting standards, (ii) given necessary resources and (iii) powers to use them. In order to streamline the process, the entire organization is broken into various types of centers mainly cost centre, revenue centre, profit center and investment centre. The organizational budget is divided on these lines and passed on to the concerned managers. Actual results are collected and displayed in the same form for comparison. Difference, if any, are highlighted and brought to the notice of the management. This process is called Responsibility Accounting.

RESPONSIBILITY CENTRE

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A FORMAL DEFINITION OF RESPONSIBILITY ACCOUNTING


Responsibility accounting involves the creation of responsibility centres. A responsibility centre may be defined as an organization unit for whose performance a manager is held accountable. Responsibility accounting enables accountability for financial results and outcomes to be allocated to individuals throughout the organization. The objective is to measure the result of each responsibility center. It involves accumulating costs and revenues for each responsibility centre so that deviation from performance target (typically the budget) can be attributed to the individual who is accountable for the responsibility centre.

Responsibility Centre and their Evaluation


RESPONSIBILITY CENTRES Revenue Centre EVALUATION METHODS Sale Price Variance Sale Quantity Variance Sale Mix Variance Cost Centre Raw Material Variances: Labou)r Variances Overhead Variances Profit Centre Gross Profit Contribution Margin Investment Centre ROI Residual Income Economic Value Added ADVANTAGES DISADVANTAGES Helps manage a large and diversified May create conflicts between various organization divisions Motivate Manager to optimize their Undue competition may become performance dysfunctional Narrows down vision as overall company Provide manager freedom to make local prospective are not considered by decisions individual managers. Top management get more time for May prove costly due to duplication policy making and strategic planning Supports management and individual specialisation based on comparative Problem in coordination across divisions Advantages

MANAGERIAL PERFORMANCE AND ECONOMIC PERFORMANCE


All businesses operate in a complex environment. The traditional approach of centralized control is not possible. There is a shift towards decentralization. At the same time, the management wants to retain some sort of control over activities of its managers. When authority is decentralized and passed on to managers, there is a problem of goalcongruence. This means that the management will constantly review all operations and activities of individual divisions to insure that none of them is working against the overall objectives of the company. Such a behavior is called dysfunctional and is damaging to the company. While evaluating, performance of an individual manager, two factors have to be considered:
Should the managers job be separated and a manager is rewarded or penalized

only for those activities over which the manager has control.
Should the managers decision be seen in a wider prospective and final judgment

be given only after reviewing full impact of such decisions. It is obvious that a manager's decisions should be evaluated after seeing their impact on the bottom line i.e. profitablity of the comany. But such policy would not be motivational for the individual manager and the good results may be nullified by the factors not under the control of the particular manager. Hence, the company follows first appraoch i.e. managerial performance.

CONSOLIDATED P&L Accounts

An example to explain Responsibility Accounting


An integrated textile unit showed a net profit after tax of Rs.272 million. Its ROI (Return on Investment), was 17.5% which is much above the supposed cost of capital of 12.5%. The company was operating three divisions: (i) Spinning Unit, (ii) Weaving Unit and (iii) a Finishing Unit. As of now, it is not apparent who earned what. So managers of the three departments would be asking for bonuses or rewards. Now suppose, the company asks its accountants to prepare Division-wise P&L account and present the same to the management for performance appraisal of the three managers.

DIVISION WISE ACCOUNTS

After considering division-wise performance, who do you think deserve the bonus? Only the manager, Spinning Division, deserves the bonus. Manager Weaving has just broken even by earning profit equal to cost of capital. Manager Finishing was really a drag on the companys resources and its losses were only hidden in consolidated statements because of substantial contribution made by Spinning Unit. However, this is over-simplified example but it brings glaring facts to the notice of the management and other users of the accounts.

PACKAGES LTD - ORGANIZATIONAL CHART

RESPONSIBILITY CENTRES
Packages Ltd had two autonomous units, Lahore Plant and Karachi Plant. In our responsibility accounting terminology, these would be called Investment Centres. General Manager, Lahore Plant, can decide how much to invest on what. (Of course, he would be guided by a multi-functional teams which includes industrial engineers, economists, researchers and financial analysts.) The GM, Lahore Plant would be evaluated on the basis of ROI or RI or EVA. And so the GM, Karachi Plant. The yardsticks would remain the same in the case of both the Managers. In the second Layer there are Managers of Paper Mills, Packaging Plant and Printing Plant. All of them have been given necessary Production Facilities and working Capital. Their performance would be based on Gross Margin or Contribution Margin. The latter is a better measure since it does not take into account fixed cost (Depreciation, Salaries of Permanent staff and markup) over which the Manger has no control. (Decisions for capital investments are made in the Investment Centers). In the last layer there are three sections. The first two are classified as Cost Centers and their managers should try to remain within their allocated budgets. The third one, Marketing

Cell, is a Revenue Centre and its manager must exert as much as possible to bring the business as per target level or budget level.

CONCLUSION
There are no set rules or Generally Accepted Accounting Principles (GAAP) in management accounting which serves the management and not outsiders. So performance reports may be prepared in any form and styles as long as these give useful information to the Chief Executive and the top-managers. One such format is given above. The modern business concerns adopt a variety of way to achieve their goals. Since a Chief Executive cannot over-see all affairs of a company in different fields, in different locations and in different time-frames, he or she introduces a systematic control through budgets and responsibility accounting techniques. The organization is broken into various responsibility centres. The Accountant maintains records for each of the centre and periodically prepare and submit reports on their performance which ultimately reflect on the capability of its managers. To use such techniques effectively, the emphasis must be on the useful information rather than a blame game or passing on the buck. The managers should be provided feedback as to how near or away they are from their targets. These reports should be well in time to allow them to adjust their approach. The ultimate aim would be welfare of the organization and its gradual rise in the industrial sector. In the process, good managers must be rewarded and bad one eliminated to stay afloat in a most competitive and dynamic environments.

Responsibility Accounting.

The creation of divisions allows for the operation of a system of responsibility accounting. Responsibility accounting is a system of accounting that segregates revenues and costs into areas of personal Responsibility in order to monitor and asses the performance of each part of an organization. A Responsibility center is a department or organizational function whose performance is the direct responsibility of a specific manager. In the weakest form of decentralization a system of cost centers might be used. As decentralization becomes stronger the responsibility accounting framework will be based around profit centers. In its strongest form investment centers are used. Investment centers. Where a divisional manger of a company is allowed some discretion about the amount of investment undertaken by the division, assessment of results by profit alone (as for a profit centre) is clearly inadequate. The profit earned must be related to the amount of capital invested. Such divisions are sometimes called investment centers for this reason. Performance is measured by Return on Capital Employed, often referred to as Return on Investment and other subsidiary ratios, or by Residual Income (RI). An investment center is a profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment. Managers of subsidiary companies will often be treated as investment centers Managers, accountable for profits and capital employed. Within each subsidiary, the major divisions might be treated as profit centers with each divisional manger having the authority to decide the process and output volumes for the products or services of the division. Within each division, there will be departmental Managers section Managers and so on, who can all be treated as cost center Managers. All Managers should receive regular, periodic Performance reports for their own areas of responsibility. The amount of capital employed in an investment center should consist only of directly attributable fixed assets and working capital. o Subsidiary companies are often required to remit spare cash to the central treasury department at group head office. And so directly attractable working capital would normally consist of stocks and less creditors, but minimal amounts of cash. o If an investment center is apportioned a share of head office fixed assets, the amount of capital employed in these assets should be recorded separately because it is not directly attractable to the investment centre.

The use of the responsibility centres concept to structure an organization

In principle the Board of Management has the authority to make decisions within a multinational enterprise (MNE). Decisions by the highest management level within an enterprise about delegation of this authority or decentralization will be influenced by the following four factors: Maximum span of control The management style concerning the control and steering of the MNE Transaction costs The strategy and the business model applied by the MNE. By delegation of its authority the top management will determine how a manager to whom authority is delegated will be compensated and/or how the manager will be steered and controlled. Example: The Management Board of a French MNE gives the sales director of its German sales company the task to double turnover within a period of 3 years. In this case, one can opt to give the sales director a bonus on the basis of (a) solely the doubling of turnover or (b) a minimum required level of profitability of the sales company. The choice between a revenue centre (situation (a)) and a profit centre (situation (b)) depends on the four factors above. Also, in making this choice it is important to what degree the German sales company is considered to be able to manage and control the functions and risks related to situation (b). This information can generally be obtained on the basis of the traditional functional analysis techniques as described in the OECD Transfer Pricing Guidelines. In summary, no cases are the same in practice in respect of the choices of roles and responsibilities. However, in order to structure the analysis of an existing situation, a number of tools are given below, describing the features of the most common types of responsibility centres. The following descriptions address the following variables: The relationship between inputs and outputs of the responsibility centre determines the label. A responsibility centre can in practice consist of a department, a business unit, a legal entity, a geographical unit etc. A description of the type of activities which are common per responsibility centre A number of examples per responsibility centre The steering and control concept per responsibility centre The most common compensation method, both from a management and a tax perspective The legal framework.

Practical descriptions of responsibility centres


The following schedules are illustrations of the classification of certain activities as an expense centre, cost centre, revenue centre, profit centre or investment centre. In addition to the usual analysis of functions, risks and the use of assets per part of the MNE, the responsibility centre label adds a more process-oriented view on to the MNE, whereby one tries to identify (a) roles and responsibilities within a MNE and (b) value-added decisions. Example: In the Italian parent company of a MNE all business decisions are made, whereas the parent company through the compensation method applied has been classified as a cost centre. The costs of the parent company are charged to the Belgian subsidiary, which formally acts a principal company in other words, it gets the classification profit centre. However, taking into account that the staffing in Belgium is limited to factory workers, the responsibility centre labels given the allocation of roles between Italy and Belgium appear to be in conflict with the economic reality in terms of value-adding decision

making.

Expense centres

Relationship input/output - inputs are expressed in euros, outputs in units - output level and cost standards not or hard to determine Type of activities - strategically or operationally necessary - (almost) exclusively performed for group - mostly core Examples - highly creative, non repetitive tasks, e.g. core research - corporate strategy department, e.g. strategic marketing Towards steering/control - determine expense/cost level (= budget) - monitor actual expenses/cost per department / account - focus on quality of processes, people and technology applied Common transfer pricing policy - actual cost are charged or allocated to recipient (budgeted costs +/- variances) - actual cost/benefit ratio is frequently reviewed - profit margin is meaningless from a managerial point of view - profit margin will be required for tax purposes Legal framework - mostly development contract or service level agreement

Cost centres (= engineered expense centres)

Relationship input/output - inputs are expressed in euros, outputs in units - output level and cost standards can be determined Type of activities - operational activities, managed by principal entity - mostly performed for group - mostly non-core Examples - subcontracting of manufacturing activities - facility management activities - supporting activities of treasury department - IT system maintenance activities Towards steering/control - determine cost standards/targets per product etc. - monitor actual costs per product etc - analyse controllable and non-controllable variances - focus on cost/quality relationship - allows benchmarking of equivalent activities Common transfer pricing policy - standard cost times actual volumes are charged - sometimes non-controllable variances are settled - to apply a profit mark-up creates pseudo profit centre - profit margin could be applied from a managerial point of view - profit margin will be required for tax purposes, unless a third party would not be able to charge a mark-up Legal framework - mostly service level agreement

Revenue centres

Relationship input/output - inputs and outputs are expressed in euros - output level and cost level not directly related Type of activities

- market/customer driven activities - mostly performed for external customers - mostly core Examples - sales and distribution activities Towards steering/control - determine and monitor revenue levels - maximize quantities or prices Common transfer pricing policy - allocation of (contribution) margin of sales revenue Legal framework - mostly service level agreements (e.g. distribution company)

Profit centres

Relationship input/output - inputs and outputs are expressed in euros - output level and cost standards can be determined Type of activities - market/customer driven activities - mostly performed for external customers - mostly core Examples - distribution activities - speculative activities of treasury department Towards steering/control - determine price levels and cost standards per product - monitor turnover, costs and profits per product - analyse variances - focus on profit contribution and quality Common transfer pricing policy - external/market price times actual volumes are charged

TPA Technical Manual for Responsibility Centres 7


Your bridge to worldwide transfer pricing services - operating profit margin should - as primary way of measuring profitability - provide an adequate return on capital employed for Legal framework - mostly service level agreement with cost centres

Investment centres

Relationship input/output - inputs and outputs are expressed in euros - relates profits to assets/underlying capital (=input) Type of activities - capital market/customer driven activities - mostly performed for shareholders/MNO as a whole - core Examples - intellectual property owners (return on investment on R&D) Towards steering/control - determine minimum required return on investment - monitor capital employed and profits per product - analyse variances on return on investments - focus on sustaining long term profitability of MNO Common transfer pricing policy1 - EVA or RONA/ROCE measures should allow monitoring an adequate return on investment - remuneration based on residual income Legal framework - wide variety of legal agreements (if any)

1 Note

that an investment centre might not always be a party to inter-company transactions. An example is where an investment centre is placed in a holding company that only receives dividends as income.

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