SEC C RC

199 Section C: Performance Measurement

Chapter 2: Responsibility Centres

Definition and Purpose

A decentralized organization is divided into responsibility centers (also called strategic business units, or SBUs) to facilitate local decision-making and to provide a basis for measuring the performance of subunits.

Characteristics of Responsibility Centres

  • Authority: Each responsibility center has the authority to make decisions affecting major determinants relevant to its center type.

Types of Responsibility Centres

  1. Cost Center

    • Responsibility: Responsible for costs only.

    • Example: Maintenance Department.

  2. Revenue Center

    • Responsibility: Responsible for revenue only.

    • Example: Sales Department.

  3. Profit Center

    • Responsibility: Responsible for both revenue and expenses.

    • Example: Department in Retail Store.

  4. Investment Center

    • Responsibility: Responsible for revenues, expenses, and invested capital.

    • Example: Branch Office.

Reporting Segments in Responsibility Centres

The effectiveness of each responsibility center is often subdivided further into additional areas of accountability, including:

  1. Product Lines or Services

    • Some SBUs may involve multiple products or services, allowing for detailed analysis of costs, sales, profits, and returns associated with each product.

    • When a company produces multiple products, a manager for each product line is typically identified to oversee all related activities.

  2. Geographic Areas

    • SBUs may span geographic boundaries. Performance can be traced by regions to give additional insight into results.

    • Managers can be assigned for each region where the company operates.

  3. Customer Segmentation

    • Segmenting by major customer types can reveal the profitability or losses associated with individual customers, influencing decisions regarding customer relationships.

    • An example is how a bank might classify segments into corporate banking, agricultural banking, and real estate lending.

  4. Process Segmentation

    • Businesses with multiple discrete manufacturing processes may categorize performance based on each process.

    • For instance, a garment manufacturer may have distinct sections for cutting, sewing, hemming, finishing, packaging, and sales, each managed individually.

  5. Time-Based Segmentation

    • Companies operating in shifts may need specific managers for different times, for example, managing staff for morning, afternoon, and night shifts.

Responsibility Center Measurement

  • Contribution Margin

    • Definition: Contribution margin measures the excess of revenues over variable costs for a company or division.

    • Calculation:
      ext{Contribution Margin} = ext{Sales Revenue} - ext{Variable Costs}

    • This dollar amount covers fixed costs, and once those are covered, contributes toward profit.

Accountability in Management

  • Managers should only be accountable for costs or other metrics they can influence.

  • Measuring Contribution by Responsibility Center is the difference between contribution margin and controllable fixed costs:

    • Controllable Fixed Costs: These are costs managers can affect within less than a year, like advertising and promotions.

    • Non-Controllable Fixed Costs: Costs that a particular manager cannot change.

Controllable Margin Calculation

  • Formula: ext{Controllable Margin} = ext{Sales Revenue} - ext{Variable Costs} - ext{Controllable Fixed Costs}

    • This is a critical measure of a manager's short-term performance.

Example Problem 1

  • Company: Delta Company, which produces gadgets.

  • Costs per Unit:

    • Direct Materials: $45

    • Direct Labour: $15

    • Variable Overhead: $10

    • Shipping Cost: $10

    • Sales Commission: 10% of sales.

  • Fixed Costs: $17,000 (60% controllable by plant manager).

  • Sales in April: 1,000 gadgets sold at $150 each.

  • Required Tasks: Calculate controllable margin and operating income for April.

Common Costs in Responsibility Centres

  • Definition: Common costs are shared across multiple responsibility centers, such as costs for accounting, IT, and HR departments that serve all areas.

    • Allocation of Common Costs: Should be rational, fair, and logical to avoid demoralizing employees, motivating them instead to align with corporate goals.

    • Common costs are typically not controllable, thus managers must recognize their shared responsibilities.

Measurement Indicators

  • The controllable margin reflects a manager's short-term performance.

  • Contribution margin by responsibility center reflects a manager's long-term performance.

Performance Measurement In addition to various responsibility centres, performance measurement concepts such as Residual Income (RI), Return on Investment (ROI), and Balanced Scorecard (BSC) are essential for evaluating financial effectiveness and strategic alignment within organizations.

Residual Income (RI)

  • Definition: Residual Income measures the amount of income an investment generates beyond the required return on its invested capital.

  • Formula:
    RI = Net \, Income - (Required \, Rate \, of \, Return \times Invested \, Capital)

  • Purpose: RI helps to assess the profitability of individual investments while accounting for the cost of capital, encouraging managers to pursue projects that generate returns exceeding this cost.

Return on Investment (ROI)

  • Definition: ROI assesses the efficiency of an investment or compares the efficiency of several investments.

  • Formula:
    ROI = \frac{Net \, Profit}{Cost \, of \, Investment} \times 100

  • Purpose: ROI offers a straightforward metric to evaluate the gain or loss generated relative to the investment cost, facilitating comparison across different investment options.

Balanced Scorecard (BSC)

  • Definition: The Balanced Scorecard is a strategic management tool that measures organizational performance across multiple perspectives.

  • Perspectives:

    1. Financial: Focuses on financial performance and how well the organization is using its resources.

    2. Customer: Evaluates customer satisfaction and market share goals.

    3. Internal Processes: Assesses internal operational efficiencies and quality.

    4. Learning and Growth: Looks at employee training and organizational culture to encourage continuous improvement.

  • Purpose: BSC provides a broader view of organizational performance, enabling alignment of business activities to the vision and strategy of the organization, improving internal and external communications, and monitoring organizational performance against strategic goals.