Chapter What you Really Need to Know

12 A. A responsibility accounting system functions best in a decentralized organization. A decentralized organization

is one in which decision-making is spread throughout the organization, with managers at all levels making
decisions.
B. To operate effectively, the manager needs much more information than that provided by a single income
statement. The manager needs information that focuses on the segments of the organization.
1. A segment is an individual unit within an organization whose manager has the responsibility to carry
out its activities. Examples of segments include sales territories, manufacturing divisions, departments,
and groups or lines of products.
2. By preparing segmented reports such as the illustration in Exhibit 12-3, the manager may uncover
problems and opportunities that otherwise would have remained undetected. For example, some
product lines may be unprofitable; some sales territories may have a poor sales mix; other sales
territories may be using ineffective promotional strategies, etc. Such problems can be highlighted with
segmented reports.
C. Two general guidelines should be used in classifying and assigning costs to the various segments when the
contribution margin approach is used.

1. First, costs are classified according to cost behaviour patterns; that is, whether they are variable or
fixed.

2. Second, costs are assigned according to whether they are traceable or common to the various
segments.

a. A traceable cost of a segment is an expense that is incurred because of the existence of the
segment and would generally be avoided if the segment were eliminated. Only traceable
costs should be charged to a segment.

b. Common costs are costs that support more than one segment, but are not directly traceable, in
whole or in part, to any one of those segments. Common costs would not disappear over time
if a segment were eliminated and therefore should not be allocated to segments for decision-
making purposes. For example, the cost of the company's executive jet is a common cost of
all the products the company sells. Even if one product was dropped entirely, it is unlikely
that there would be any significant change in the cost of owning and operating the executive
jet.

3. Exhibit 12-4 illustrates a segmented report.

D. In a decentralized organization the responsibility accounting system is structured around responsibility centres
which are segments of an organization whose manager is responsible and accountable for costs, profits, and/or
investments. The three primary types of responsibility centres are cost centres, profit centres, and investment
centres.
1. A cost centre is a responsibility centre where a manager has control over cost but not over revenues,
profit or investments. A cost centre manager is usually held responsible for minimizing cost while
providing quality goods and services as requested.
2. The manager of a profit centre has control over both cost and revenue, thus profit. A profit centre
manager is usually held responsible for maximizing profit.
3. The manager of an investment centre has control over cost, revenue, profit, and investments in
operating assets. An investment centre manager is ordinarily evaluated on the basis of return on
investment or residual income, as explained later.
E. Investment centre performance is often measured by return on investment (ROI), which is defined as:

The ROI can also be expressed in terms of margin and turnover:

where:
 1. Net operating income is income before interest and taxes (EBIT).

2. Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other
assets held for productive use within the organization. Operating assets do not include, for example,
investments in other companies and investments in undeveloped land.

a. This text uses the plant and equipment net book value, original cost less accumulated
depreciation, in the determination of average operating assets rather than the gross cost
approach.
b. Assets that are common to all divisions (such as assets associated with corporate
headquarters) should not be allocated to the divisions when making ROI computations.

3. The higher the ROI of a business segment, the greater the profit generated per dollar invested in the
segment’s operating assets. Holding all other things constant, a company's return on investment can
be improved by increasing sales, reducing expenses, or reducing average operating assets.
4. One of the advantages of ROI as a performance measure is that it forces the manager to control the
investment in operating assets, as well as to control the expenses and the margin.
5. ROI is criticized for several reasons. One of the most important criticisms is that a division manager
who is evaluated based on ROI will tend to reject projects whose ROIs are less than the division's
current ROI but greater than the company's minimum rate of return. Rejecting such a project would
not be in the best interest of the company since a project whose rate of return exceeds the minimum
rate of return should ordinarily be accepted.
F. Residual income is another approach to measuring performance in an investment centre.

1. Residual income is the net operating income that an investment centre earns above the minimum
required rate of return on operating assets.

2. The residual income approach to performance evaluation encourages managers to make investments
that are profitable for the entire company but would be rejected under ROI.
3. Unfortunately, the residual income approach can't be easily used to compare divisions of different
sizes. Larger divisions naturally tend to have larger residual incomes than smaller divisions.

G. It is fairly common for one part of a company to provide goods or services to another part of the company. For
example, the General Motors truck division sells delivery trucks to the Chevrolet Division. The price charged
for such a sale inside a company is called a transfer price.

1. The buying segment would like a low transfer price because it is a cost for the segment, while the
selling division would prefer a high transfer price because the price determines the segment’s revenue.

2. There are three methods that can be used to establish a transfer price: market-based price, cost-based
price and negotiation price. Each method has its benefits and limitations which are discussed in more
advanced texts. Irrespective of the method chosen, the objective in setting transfer prices should be to
encourage managers to make decisions that are in the best interests of the overall organization.

H. The previously discussed financial measurements of performance are quantitative only. It is also important to
consider nonfinancial measures of performance such as the dimensions of customer satisfaction, internal
business processes and learning and growth. The balanced scorecard includes these measures and is an example
of multi-dimensional performance measurement.