Responsibility Accounting

“Responsibility Accounting collects and reports planned and actual accounting informa-
tion about the inputs and outputs of responsibility centres”.

Responsibility Accounting is based on information pertaining to inputs and outputs. The

resources utilised in an organisation which are essentially physical in nature and refer to
quantities of materials consumed, hours of labour and so on, are termed as inputs. These
heterogeneous physical resources are converted into a common denominator called the
monetary measure, for the purpose of managerial control. When they are expressed in
monetary terms, they are fermed as “costs”. In a similar way, when outputs are measured
in monetary terms, they are termed as “revenues”. More precisely, responsibility
accounting is based on cost and revenue data or financial information.

Responsibility Accounting must be so designed as to suit the existing structure of the

organisation. Responsibility should be coupled with authority. A person is obliged to
perform his duties only when he is conferred with adequate powers to do so. A sound
organisation structure, with clear-cut assignment of authorities and responsibilities should
exist for the successful functioning of the responsibility accounting system. When the
organisation is not in order, it will miserably fail to work. Responsibility Accounting
system mainly depends on the assigned responsibilities and authorities such that the
performance of each manager is evaluated in terms of such factors.

Responsibility Centres:
The main focus of responsibility accounting is on the responsibility centres. A
responsibility centre is a sub-unit of an organisation under the control of a manager who
is held responsible for the activities of that centre. The responsibility centres, for control
purposes, are generally classified into: (1) Cost Centres, (2) Profit Centres and (3)
Investment Centres.

Cost Centres:
When the manager is held accountable only for costs incurred in a responsibility centre, it
is called a cost centre. More precisely, it is the inputs and not outputs that are measured in
terms of money. In a cost centre of responsibility, the accounting system records only
costs incurred by the centre/unit/division, but the revenues earned (output) are excluded
from the purview. This only means that a cost centre is a segment whose financial
performance is measured in terms of cost. The costs are the planning and control data in
cost centres, since managers are not made responsible for profits and investments in
assets. The performance of the managers is evaluated by comparing the costs incurred
with the budgeted costs. The management focuses on the cost variances for ensuring
proper control.The performance of a cost centre is measured by cost alone, without taking
into consideration, its attainments in terms of “output”.

A cost centre does not serve the purpose of measuring the performance of the
responsibility centre, since it ignores the output (revenues) measured in terms of money.
A common feature of production departments is that they are usually multiple product
units. There must be some common basis to aggregate the dissimilar products to arrive at
the overall output of the responsibility centre. If this is not done, the efficiency andl
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effectiveness of the responsibility centre cannot be measured.

Profit Centres:
When the manager is held responsible for both cost (inputs) and revenues (output) and
thus, for profit of a responsibility centre, it is called a Profit Centre. In a Profit Centre,
both inputs and outputs are measured in terms of money. The difference between
revenues and costs represents profit where the former exceeds the latter and loss when it
is vice versa. The term “revenue”with reference to responsibility accounting is used in a
different sense altogether. According to generally accepted principles of accounting,
revenues are recognised only when sales are made to external customers. For evaluating
the performance of a profit centre, the revenue represents a monetary measure of output
emanating from a profit centre during a given period, irrespective of whether the revenue
is realised or not. The underlying principle is that a department has output representing
goods and services which are capable of monetary measurement.

The relevant profit to facilitate the evaluation of performance measurement of a profit

centre is the pre-tax profit of a responsibility centre. The profit of all the departments so
calculated will not necessarily be equivalent to the profit of the entire organisation. The
variance will arise because costs which are not attributable to any single department, are
excluded from the computation of the department's profits and the same are adjusted
while determining the profits of the whole organisation. Hence, it is the divisional profit
which is required for the purpose of managerial control.

As the profit provides more effective appraisal of the manager's performance, the
manager of the profit centre is highly motivated in his decision-making relating to inputs
and outputs so that profits can be maximized. In consonance with the above objective, by
creating more profit centres in an organisation, decentralisation of activities can be easily
effected.

The profit centre approach cannot be uniformly applied to all responsibility centres. The
following are the criteria to be considered for making a responsibility centre into a profit
centre. A profit centre must maintain additional record keeping to measure inputs and
outputs in monetary terms. When a responsibility centre renders only services to other
departments at the instance of the management, e.g., internal audit.it cannot be made a
profit centre. A profit centre will gain more meaning and significance only when the
divisional managers of responsibility centres have empowered adequately in their
decision making relating to quality and quantity of outputs and also their relation to costs.
If the output of a division is fairly homogeneous (e.g., cement), a profit centre will not
prove to be more beneficial than a cost centre. Again, due to intense competition
prevailing among different profit centres, there will be continuous friction among the
centres arresting the growth and expansion of the whole organisation. A profit centre will
generate too much of interest in the short-run profit to the detriment of long-term results.

Investment Centres:
When the manager is held responsibility for costs and revenues as well as for the
investment in assets of a responsibility centre, it is called an Investment Centre. In an
investment centre, the performance is measured not by profit alone, but it is related to
investments effected, since the manager of an investment centre is always interested to
earn a satisfactory return. The return on investment which is usually referred to as ROI,
serves as a criterion for the performance evaluation of the manager of an investment
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centre. Viewed from this angle, investment centres may be considered as separate entities
wherein the managers are entrusted with the overall responsibility of managing inputs,
outputs and investment. This only represents an extension of the responsibility idea.

Return on Investment (ROI):

A very popular tool for reporting performance of an investment centre of responsibility
accounting is the rate of return on investment in assets or simply return on investment
(ROI).

Symbolically,
Net Income
ROI =
Total Assets / Investment

There are two components to the return on investment classification. They are: (1) profit
margin or margin on sales and (2) asset/investment turnover. Thus, ROI is a product of
two elements as given below:

Net Income Sales

ROI = Profit Margin × Investment Turnover = ×
Sales Assets

Net Income
ROI =
Assets

From the above it is clear that the ROI can be increased by increasing the profit margin,
by increasing the asset turnover or by some combination of the two.

There are certain benefits of using ROI as divisional performance measurement. Firstly,
ROI is generally accepted measure of overall performance. As a divisional performance
measurement, it is in conformity with the firm's rate of return analysis. Secondly, ROI
analysis is a relative measure since it comprises a ratio/percentage. This serves as a
common denominator and facilitates comparison between different divisions. This inter-
divisional comparison is of great value in the maximisation of profits of an organisation.
Thirdly, ROI provides the basis for optimum utilisation of the assets of a firm. This
enables the divisional manager to obtain or retain those assets yielding satisfactory return
and to discard the rest.

The ROI analysis which is sound and appealing, suffers from certain limitations. One
main drawback with the ROI analysis is that of determination of investment base. The
determination or measurement of the value of investment is referred to as “investment
base”. The problem of measurement of investment in assets relating to an investment
centre analysis, in turn, depends on the method of allocation/apportionment and the mode
of valuation.

Problem of Allocation:
This arises on account of the difference in the treatment of assets that are shared in
common among the different divisions. The most common examples are cash, receivables
and inventories. What is the method adopted for the allocation of such assets among
different divisions? One method is to completely ignore such assets while computing the
investment base of a division on the basis that only those assets which are exclusively
used directly traceable to a division should be included. Alternatively, the common assets
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should be apportioned among the benefited division so as to facilitate proper

measurement of their individual investments. Apart from the above, there is also the
difficulty of identification of assets with separate divisions and reasonable allocation.

Again, the problem of allocation is further complicated by the existence of number of idle
assets. If such assets are included while computing the ROI, the resulting figures would
be a return on capital employed rather than the total investments/assets. This approach
would tend to raise the ROI. This would not eventually reveal the degree of effectiveness
of the utilisation of the assets which alone forms the basic objective of the ROI analysis.
For, the presence of idle assets would indicate the ineffective utilisation of resources.

The measurement of investment base is also affected by the problem of assigning of

values to the assets of a division. There are different methods available for valuation of
assets required for ROI analysis. They are book value, gross book value (original cost)
and the current replacement costs.

The most readily available method of valuation of assets is the book value. This only
means the original cost less accumulated depreciation. But the main drawback of this
method is the declining investment base as a result of depreciation charges. When the net
income of the division remains constant or does not dechne as fast the book value of the
division's assets, the divisional ROI would show improving performance which is not
really the case.

The Gross Book value which represents the original cost without any deduction for the
depreciation, holds a partial solution to the ROI analysis based on book values. When the
earnings remain constant, this approach will give a constant ROI over a period of year.
Though it avoids the unnecessary rise in the ROI with the passage of time, it is not a
measure of the current economic values of the assets concerned.

The current replacement cost basis provides the best measure of the current performance.
The underlying problem is the determination of the replacement cost which becomes
materially subjective assessment.

Net Income:
Another element involved in the computation of ROI is the net income/profit of a
responsibility centre; there are certain complications in the determination of the net
income of a division. More precisely, an investment centre which is only an extension of
a profit centre encounters all the problems of the latter, besides, there are certain special
problems connected with the income measurement. They devolve on the treatment of tax
and interest which are outside the purview of the divisional managers. The adjustment of
these items in the calculation of the divisional income is open to question. As per the
incremental approach, since these items do not fall in the area of responsibility of a
division, they are to be excluded. Whether depreciation should be based on historical cost
or replacement cost is yet another ticklish issue. It is but logical that when the basis of
valuation of assets adopted is replacement cost, the depreciation should also be based
upon the same. In short, the items having a bearing on net income can be treated in
different ways. This results in some complications in the measurement of net income for
ROI analysis.

Residual Income
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Residual Income is yet another approach for measurement of financial performance in an

investment centre. This measure of divisional performance avoids some of the problems
encountered in the ROI analysis. Residual income represents that amount which remains
after deduction of “implied” interest charge from the operating income. The implied
interest charge refers to the opportunity cost. The basis for computation of interest is the
value of assets in each investment centre. The rate of interest so calculated will be
equivalent to the minimum rate on investment expected by the top management. In fact,
the difference between the actual operating income and the required/expected income is
residual income.

The residual approach has certain merits to its credit. Firstly, it encourages capital
investment by a divisional manager whenever he expects to earn more than the
required/expected cut-off rate. More precisely, any new investment by the divisional
manager will increase the residual income provided it yields a higher income than the
required/expected cut-off percentage. Secondly, this allows different rates of return for
different divisions/assets.

Conclusion:
In conclusion it can be stated that the responsibility accounting is relevant to divisional
performance measurement. Of the three types of responsibility centres, an investment
centre type of responsibility centre which is only an extension of a profit centre, can be
considered to yield better results. Among the various approaches of performance
measurement in investment centre analysis, residual income is evidently superior, though
ROI is more popularly used in business circles.