Management Control Systems_Session2

7/28/2019 Management Control Systems_Session2

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Management Control Systems

Session 2


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Session 1

Responsibility center

Revenue & expense center

Profit center


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What is a responsibility center ?

Organization unit that is headed by a manager

who is responsible for its activities.

A company is a collection of responsibility

centers

They form a hierarchy with sections,

departments, work shifts etc.


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What is a responsibility center?

In simple words: an organizational unit for

which a manager is made responsible.

Examples: A specific store in a chain of grocery

stores.

A work-station in a production line

manufacturing automobile batteries.

The payroll data processing center within a

firm.


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Nature of a responsibility center

They exists to accomplish one or more

purposes, termed as objectives.

The objectives of these centers are to help

implement the strategies set to accomplish

the goals of the company.

They receive inputs and performs its particular

function, with the ultimate objective of

transforming its inputs into outputs.


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Measuring inputs and outputs

In the courier example, the inputs are causal

and direct: e.g. no. of packets received to time

taken to deliver them.

But, such causal and direct relationships are

not always possible. For example, how does

advertising contribute to increase in

revenues?

Or, how would you measure the contribution

of R & D to product innovation, revenue

generation, or cost reduction?


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Converting the inputs into monetary units

Most organizations would convert the physical

inputs into monetary units when evaluating a

responsibility center.

No. of units x cost of production, labor hours x

per hour rate, etc.


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Measuring outputs

Measuring outputs is more difficult. This is

because:

Input may be extended this year but outputs

(benefits) may be received over several years

(e.g. employee training).

It would be difficult to make the causal

relationship e.g. marketing expenses, IT

investments, accountants and generation of

revenue and profits.


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The input-output attributes

Most organizations use financial controls cost,

revenue, and profits, etc.

However, such measures are not applicable to all

units within an organization. For example, how would you measure the

contribution of a production department? It can

only be done on a cost measurement basis.

How would you measure the contribution of a sales

department only by revenue generated.


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Why does an organization

relate input to outputs?

Because they inherently measure efficiency and effectiveness.

Efficiency: ratio of output to inputs;

Caution: Do not use ratio of output to input in an absolute

sense; but, only in a comparative sense. If Dept. A is more efficient than Dept. B, do not rush to

conclusions; examine why Dept. B is less efficient and what

can be done about it.

Also, comparisons are possible only if Dept. B and Dept. A usecomparable outputs and comparable inputs. You cannot

compare advertising to accounting.


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Efficiency

Efficiency is generally measured by comparing

actual costs to standard costs.

Issues:

Standard costs do not remain stationery.

Recorded costs are often different from actual

resources (costs) consumption.

Lesson: Establishing a responsibility center is

easy; Measuring its efficiency in a reasonable

manner is difficult.


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Effectiveness

Relationship between a responsibility centers

output and its objectives (what it was

intended to do or perform or deliver).

If the output contributes to satisfying the

objectives, the more effective it is.

The new advertising and marketing efforts has

increased awareness and recognition of our

product. Advertising and marketing has been

effective.


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Efficiency-Effectiveness

Not a compromise

A responsibility center must both be efficient

and effective.

It must use the least amount of inputs to get

the maximum amount of output and yet

deliver on the goals.

A sales department was efficient in growing

the sales by 10% without adding additional

sales people or marketing expenses (efficient);

however, many of the credit sales could not be

collected (bad debts). It is ineffective.


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Role of Profit

The goal of every for-profit organization is earn profits

(effectiveness).

If the organization could use the least input to get the

maximum earnings, profits will be high (efficiency).

Therefore, profit is an indicator of both efficiency and

effectiveness.

However, not every unit within an organization earns profit

and therefore, this measure cannot be used for allresponsibility centers.

Therefore, an organization must establish various types of

responsibility centers.


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Example: A courier service (DHL)

Courier operations dispatch trucks to pick up or deliver

shipments from local terminals.

It could be sent to one or more central terminals and then

sorted and redirected.

Success of this service would depend on:

Service commitment to customers (on time, without damage) and

Controlling costs

Let us suppose that each terminal is treated as a responsibility

center.

How should the company measure the performance of each

terminal, its mangers, and its employees?


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Measuring the performance of the

courier-terminal responsibility center

To focus on efficiency: we could measure no. of parcels picked

up, sorted or delivered, per route, per employee, per vehicle,

per hour or per shift.

To focus on customer service, we could measure each groups

contribution to customers: proportion of the time the

terminal met its deadlines, when terminals are required to

sort shipments, what the sorting error rate was.

We could also measure customer service by: no. of complaints

operations group receives, average time taken by theoperation group to respond to complaints, and no. of

complaints of poor, or impolite service.


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Measuring inputs and outputs

In the courier example, the inputs are causal

and direct: e.g. no. of packets received to time

taken to deliver them.

But, such causal and direct relationships are

not always possible. For example, how does

advertising contribute to increase in

revenues?

Or, how would you measure the contribution

of R & D to product innovation, revenue

generation, or cost reduction?


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Types of Responsibility Centers

Revenue Centers

Cost Centers or Expense Centers

Profit Centers and Investment Centers


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Revenue Centers

Responsibility Centers whose members

control revenues but,

Not the manufacturing or acquisition cost of

the products or services they sell, or

In other words, you cannot link the input to

the output.


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Revenue Centers (continued)

Most revenue centers may not set selling prices

They definitely have no control over the costs ofinput acquired (service manager of an automobileworkshop does not control gasoline costs)

These centers are generally not allocated costs of thegoods that they market (there are exceptions).Manager is responsible only for costs directlyincurred by his/her unit.

They are evaluated on the basis of actual sales ororders booked against budgets or quotas and

Example: a unit of a chain store in a mall.


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Expense/Cost Centers

Responsibility centers whose employees control costs, but do

not control their revenues or investment level.

Examples: Production department in a manufacturing unit, a

dry cleaning business

Two types of costs:

Engineered: those costs that can be reasonably associated with a cost

center direct labor, direct materials, telephone/electricity consumed,

office supplies.

Discretionary: where a direct relationship between a cost unit andexpenses cannot be reasonably made; Management allocates them

on a discretionary basis (e.g. depreciation expenses for machines

utilized).

Diff b i d &


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Difference between engineered &

discretionary expense center

Engineered expense center

The budget represents the

unit cost of performing its

task efficiently The cost are affected by

short run volume changes

Objective is to become cost

competitive Measurement of

performance is to send less

for the same level of output

Discretionary expense center

Budget represents the

amount required to do the

particular level of job. Insulated from such short

term fluctuations

Financial control is

exercised at the planningstage before the cost is

incurred

Measurement of

performance is to obtain

the desired output


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Expense centers (continued)

Comparing Budgeted and Actual Costs

Budgeted costs are target estimates.

It points to a goal to be achieved.

But, it is not written in concrete.

Actual costs are that were incurred during a given period. The difference between the two could be either positive or

negative variances.

However, making conclusions on the basis of positive or

negative variances must be done carefully.


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Morton Carpets Budget (fixed)

Prod. 1 Prod. 2 Prod. 3 Prod. 4 Total

Units made 245,000 385,000 636,000 1,250,000

Units per batch 500 2,500 1,500 5,000

No. of batches 490 154 424 250

Cost per unit $ 5.40 $3.20 $4.25 $1.45

Cost per batch $325.00 $680.00 $400.00 $135.00

Unit-related costs

(245,000x$5.40)

$1,323,000 $1,232,000 $2,703,000 $1,812,500 $7,070,500

Batch-related costs

(490x$325)

159,250 104,720 169,600 33,750 467,320

Prod.-sustaining costs 125,000 168,000 256,000 355,000 904,000

Facility costs 1,450,000

Total cost center costs $9,891,820

C l


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Morton Carpets Actual costs


Units made 295,200 345,000 675,000 950,000

Units per batch 600 2,300 1,800 6,000

No. of batches 492 150 375 159

Cost per unit $5.43 $3.18 $4.33 $1.40

Cost per batch $335.00 $670.00 $387 $144.00

Unit-related costs $1,602,936 $1,097,100 $2,922,750 $1,330,000 $6,952,786

Batch-related costs 164,820 100,500 145,125 22,896 $433,341

Prod.-sustaining costs 133,000 163,000 259,000 362,000 $917,000




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Morton Carpets - Variance Analysis

Budget Actual Variance

Unit related costsProduct 1 $1,323,000 $1,602,936 ($279,936)

Product 2 $1,232,000 $1,097,100 $134,900

Product 3 $2,703,000 $2,922,750 ($219,750)

Product 4 $1,812,500 $1,330,000 $482,500

Total $7,070,500 $6,952,786 $117,714

Batch related costsProduct 1 $159,250.00 164,820 ($5,570)

Product 2 104,720 100,500 $4,220

Product 3 169,600 145,125 $24,475

Product 4 33,750 22,896 $10,854

Total $467,320 $433,341 $33,979

Prod. sus. Costs

Product 1 125,000 133,000 ($8,000)

Product 2 168,000 163,000 $5,000

Product 3 256,000 259,000 ($3,000)

Product 4 355,000 362,000 ($7,000)

Total $904,000 $917,000 ($13,000)

Fac. Sus. Costs 1,450,000 1,650,000 ($200,000)

Total $9,891,820 $9,953,127 ($61,307)


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What do we learn from the variance analysis of

Morton Carpets?

The variance analysis presents a mix of

positive and negative variances.

Example: Product 1 and 3, unit-related costs

were higher than planned, and

For products 2 and 4 they were lower than

planned.

In total, the unit-related costs and batch-

related costs were lower than planned and the

product-sustaining and facility-sustaining costs

were higher than planned.


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What can we conclude about

Morton Carpets?

Based on initial analysis, manufacturing is able to controlunit-related and batch-related costs, but

Did not do so well controlling product-sustaining and facility-sustaining costs.

A closer examination, however, casts doubts on theseconclusions.

If you look , you will notice that the no. of units actually madediffered from budgeted for all four products.

Similarly, no. of units per batch actually produced differedfrom budgeted units per batch.

Because of these volume differences, it is inappropriate tocompare the cost targets in the master budget with actualcost results.


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What can managers do to make the numbers

comparable and meaningful?

Use a flexible budget

Flexible budget recasts cost targets in the planned or

budget to reflect the achieved level of production.

The flexible budget develops cost target levels basedon actual level of activity.

See the next set of slides.


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Morton Carpets Flexible Master Budget


Units made 295,000 345,000 675,000 950,000

Units per batch 500 2,500 1,500 5,000

No. of batches 590 138 450 190

Cost per unit $5.40 $3.20 $4.25 $1.45

Cost per batch $325.00 $680.00 $400.00 $135.00

Unit-related costs $1,593,000 $1,104,000 $2,868,750 $1,377,500 $6,943,250

Batch-related costs 191,750 93,840 180,000 25,650 $491,240

Prod.-sustaining costs 125,000 168,000 256,000 355,000 904,000




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Flexible Budget Cost Analysis

Budget

Flexible

budget Actual Variance Variance

Unit related costs Budget - Flexible flexible budget - actual

Product 1 $1,323,000 $1,593,000 $1,602,936 ($270,000) ($9,936)

Product 2 $1,232,000 $1,104,000 $1,097,100 $128,000 $6,900

Product 3 $2,703,000 $2,868,750 $2,922,750 ($165,750) ($54,000)

Product 4 $1,812,500 $1,377,500 $1,330,000 $435,000 $47,500

Total $7,070,500 $6,943,250 $6,952,786 $127,250 ($9,536)Batch related costs

Product 1 $159,250.00 $191,750.00 164,820 ($32,500) $26,930

Product 2 104,720 93,840 100,500 $10,880 ($6,660)

Product 3 169,600 180,000 145,125 ($10,400) $34,875

Product 4 33,750 25,650 22,896 $8,100 $2,754

Total $467,320 $491,240 $433,341 ($23,920) $57,899

Prod. sus. Costs

Product 1 125,000 125,000 133,000 $0 ($8,000)Product 2 168,000 168,000 163,000 $0 $5,000

Product 3 256,000 256,000 259,000 $0 ($3,000)

Product 4 355,000 355,000 362,000 $0 ($7,000)

Total $904,000 $904,000 $917,000 $0 ($13,000)

Fac. Sus. Costs 1,450,000 1,450,000 1,650,000 $0 ($200,000)

Total $9,891,820 $9,788,490 $9,953,127 $103,330 ($164,637)


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What did we infer from the

flexible budget slides?

Cost standards are the same as in the case of the fixed budget.Why?

Difference: volume levels are adjusted to reflect achieved levelof activity (e.g. Product 2 was 345,000 and std. batch size of2,500 or 345/2.5 = 138 batches).

Using std. unit cost of $3.20 and std. batch cost of $680, unit-related and batch-related costs for Prod. 2 should have been$1,104,000 (345,000 x $3.20) and $93,840 ($680 x 138).

Planned variance reflect cost adjustment needed to show thedifferences in production volume between master budget and

flexible budget. positive variance means a cost reduction due to lower volume

and a negative variance means a cost increase because of ahigher volume.

Flexible budget variances are the focus of cost control in a cost

center.


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Cost/Expense center variances

A few pointers

Dont rush to conclusions based on positive or

negative variances.

Find the cause behind the variances.

Decompose the flexible budget variances for unit-related costs into price and quantity components.

Since analysis of variances for batch-related,

product-sustaining, and facility-sustaining costs is notformalized and proceeds on an ad hoc basis, Use

your common sense and rationale as a neutral

evaluator.


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Profit Centers

Managers of profit centers control both the

revenues and costs of the product or service

they deliver.

It is like an independent business except it is

part of a larger organization (e.g.

departmental stores of larger chains Wal

Mart, restaurants, corporate hotels such asHilton, Holiday Inn).

The store manager would have responsibility

for pricing, product selection, and promotion.


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Profit Centers (continued)

Cost for these units vary depending on ability

to control labor, waste, and hours.

Revenues also will vary depending on the

units service level, location, etc.

In other words, local discretion would affect

revenues and costs.

Therefore, profits represent a broader index of

both corporate and local decisions.


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Profit Centers (continued)

If performance is poor, it may reflect poor

conditions that no one in the organization

could control as well as poor local conditions.

For this reason, organizations should not

evaluate performance only based on costs and

profits, but

Perform detailed evaluations that includequality, material use, labor use, and service

measures that the local unit can control.


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Investment Centers

Responsibility centers whose managers and

employees control revenues, costs, and the

level of investment.

It is also like an independent business

(common when an organization acquires

another organization e.g. Sears financial

centers).


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Administrative Centers (support centers)

One of the most difficult to evaluate because neither

the input nor the output is easy to measure (e.g.

accounting services, marketing), and

Linking units input and output to organizationalobjectives.

But, with a little careful approach, the costs of such

centers can be reasonably computed.

Since most of these centers are treated somewhatlike cost centers, an approach based on costs would

be helpful.


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Administrative Centers (support centers)

Include senior corporate management and other managers

that provide services to other responsibility centers

The control of administrative expenses is difficult due to

problems in measuring output and the frequent lack of goal

congruence of the departments & the company.

This problem arise with the size and prosperity of the firm.

Budgets are prepared annually. It covers

Basic cost of responsibility center

Discretionary activities of responsibility centers

Justification for proposed budgeted increase


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Research & development center

The head of the R&D department wants to build the bestresearch organization.

There is however a difficulty is relating results to inputs and

there is lack of goal congruence

In some companies basic research is included as a lumpsum inthe research program and its budget

For projects involving product testing, it is possible to

estimate the time and financial requirements.

R&D is a discretionary expense and it is difficult to budget forthe same on a scientific basis. Most companies use a % of

average revenue.


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Marketing centers

They perform marketing ( order getting) activities and logistics

(order filling) activities.

Marketing activities are those which are necessary for getting

orders from the customers. They include advertising, publicity

and test marketing.

The logistic activity


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A simple summary of the

responsibility centers

Revenue CenterOutput measured in

monetary terms

Input measured inmonetary terms

Output measured in

monetary terms

Output measured in

monetary terms

Expense/Cost Centers

Profit Centers

Investment Centers

/


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Responsibility budgeting/

responsibility accounting

System of control by delegating & locating the

responsibility for costs.

There is identification of costs with the person

responsible.

This works best in a decentralized operation.

this involves change in emphasis from

product costing to responsibility costing.

P i i f ibili


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Pre-requisites for responsibility

costing The area of responsibility & authority should be clearly

defined

Each responsibility center should have a clear set of goals for

the managers.

The performance report should include revenues, exps etc.

which are controllable by the managers.

The manager should participate in establishing the goals of

the organization

Performance reports should be prepared highlighting the

variances, the items that require managers attention.


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Responsibility accounting

Advantages

Relieves top management

from every day decision

making

Better training to the

managers

Limitations

It results in loss of

economies of scale

Requires elaboratecommunication

Leads to confusion in

decision making.


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What did we learn from these

control system illustrations?

All responsibility centers evolve from the concept of

controllability.

Controllability principle states a manager should be assigned

responsibility for the revenue, costs, or investment that

he/she could control.

Revenues, costs, or investments that do not fall under a

managers control must be excluded when evaluating the

manager or his/her center.

Problem with this concept: In most organizations, manyrevenues and costs are jointly earned or incurred and

differentiation the controllable from the uncontrollable is

difficult.


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An alternative to Controllability

Some argue that performance measures

should be chosen to influence decision-

making behavior.

For example, if market prices for raw material

is increasing, what can a manager do?

Perhaps, enter into long term contract for

fixed prices for raw materials.

If electricity consumption cost is going up, find

out how consumption can be economized

(better machines, lighting, reduce waste).


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Questions 2011

Briefly describe responsibility center,

engineered expense center, discretionary

expense center, revenue center, profit center.

How is the performance of the head of thesecenters evaluated


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Questions 2010

What is responsibility center. List & explain

different types of responsibility centers with

sketches

Briefly describe engineered expense centersand discretionary expense centers. How is the

budget prepared in each and how is

performance evaluated in each


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Questions 2009

What is responsibility center. List & explain

different types of responsibility centers with

sketches


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Questions 2008

Explain responsibility center and map the

process of evolution thereof from once stage

to another with the help of illustrations cum

experiences of the corporates.

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