Responsibility Centres

Research & Development Centres. The control of R&D centres which are also discretionary expense centres is difficult for following reasons: 1 Results are difficult to measure quantitatively As contrasted with administrative activities R&D usually has at least a semitangible output in patents,new products or new processes.Even if the value of the output can be calculated,it is usually not possible for management to evaluate the efffciency of the R&D effort because of its technical nature.2 The goal congruence problem in R&D centres is similar to that in administrative centres.Research people often may not have sufficient knowledge of the business to determine the optimum direction of research effforts.

 Research and development can seldom be controlled effectively on an annual basis.R&D should be looked at as a long term investment,not as an activity that varies with short run corporate profitability. The R&D continuum Activities conducted by R&D organisations lie along continuum. At one extreme is basic research the other extreme is product testing,it has two characteristics(a) it is unplanned (b)there is long time lag before basic research results in successful new product introductions.

 Financial control systems have little value in managing basic research activities.In some companies basic research is included as a lump sum in the research programme and budget.In others no specific allowance is made for basic research as such. For product testing projects on the other hand the time and financial requirements can be estimated,not as accurately as production activities, but with sufficient accruacy so that a comparison of actual and budget amounts has some validity.

 R&D programme There is no scientific way of determining the optimum size of the R&D budget.In many companies the amount is specified as a percentage of average revenues:average rather than annual revenue for a specific year,is used because the size of R&D organisation should not fluctuate with short term swings in revenue.

 Anuual Budgets The annual budget is the calendarisation of th expected expenses for the budget period.If the anuual budget is in line with the strategic plan and the approved projects ,the budget approval is routine,and its main function is to assist in cash and personnel planning. Measurement of Performance In many companies two types of financial reports are provided to management..The first type compares the latest forecast of total cost with the approved amount for each active project.The second type is a report of actual expenses in each responsibility centre compared with the budget amounts.Management makes judgements about effectiveness,partly on the basis of these progress reports but primarily on the basis of face-to-facediscussions.

 Marketing Centres-One set of activities relate to filling ordsers,an they are called order filling or logistic activities.The other type relates to efforts to obtain orders.These are two marketing activities and sometimes labelled as such.Alternatively,they may be called order getting activities.Order filling activities take place after an order has been received,and order getting activities take place before an order has been received.

 Logistics Activities Logistics activities Are those involved in moving goods from the co. to its customers and collecting the amounts due from customers.They include transportation to distribution centres ,warehousing,shipping and delivery,billing and the related credit function,and collection of accounts receivable.The responsibility centres that perform these functions are fundamentally similar to expense centres in manufacturing plants.

 Marketing Activities-Marketing activities are those carried on to obtain orders.They Include test marketing,establishing,training and supervising the sales force,advt.,and sales promotion.These activities have important characteristics that affect the management control problem.The output of a marketing organisation can be measured ,however it is difficult to evaluate the effectiveness of the marketing effort because the environment in which it operates cannot be controlled.Economic conditions or competitive actions over which the marketing dept has no control,may be different from that expected when sales budgets were established.

Profit Centres
Conditions for Delegating Profit Responsibility-many management decisions involve proposals to increase expenses in the expectation of greater increase in sales revenue;such decisions are said to involve expense/revenue trade-offs.Before such trade off decisions can be delegated safely to a lower level manager,two conditions should exist. (i)The manager should have the relevant information to make expense/revenue trade-offs. (ii)There should be some way to measure how effectively the manager is making these trade offs. A major consideration in identifying profit centres is to determine the lowest point in an organisation where these two conditions prevail.Management must decide whether the advantages of giving profit responsibility offset the disadvantages.

 Advantages (i)speed of operating decisions may be increased.(ii)the quality of many decisions may be improved(iii)headquarters management may be relieved of day to day decisions and can concentrate on broader issues.(iv)Profit consciousness may be enhanced(v)Measurement of performance Is broadened.(vi)Managers should be freer to use their imagination and initiatives.

 A profit centre provides an excellent training ground for general management. If a co. has a strategy of diversification ,the profit centre structure facilitates use of different specialities and experts in different types of business. Profit centres provide top management with information on the profitability of components of the company. Profit centres are subject to pressure to improve their competitive performance.

 Difficulties with Profit Centres To the extent decisions are decentralised,top management may lose some control. (ii)Competent general managers may not exist in a functional organisation (iii)Organisation units that were once cooperating as functional units now compete with one another disadvantageously.(iv)Friction can increase (v)There may be too much emphasis on short run profitability(vi)There is no complete satisfactory system for ensuring that each profit centre,by optimising its own profit will optimise company profit.(vii)the quality of certain decisions may be reduced because headquarter has better information than the average profit centre manager.((viii)Divisionalisation may cause additional costs.

 Business units as Profit Centres Business units are usually set up at profit centres.Business unit managers tend to control product development manufacturing,and marketing resources. A busineness unit managers authority may be constrained ;such constraints should be incorporated in designing and operating profit centres.

 Constraints on Business unit Authority To realise fully the advantages of profit centre concept,the business unit would have to be as autonomous as the president of an indedpendent co.As a practical matter however such autonomy is not feasible.Business unit structures represent trade-offs between business unit autonomy and corporate constraints.The effectiveness of a business unit organisation iuis largely dependent on how well these trade offs are made.

 Constraints from other business units-It is useful to think of managing profit centres in terms of control over three types of decisions.(i)the product decision(what goods or services to make and sell)(ii)the Procurement or sourcing decisions (how to obtain or manufacture goods or services) (iii)the marketing decision (how,where and for how much are these services and goods to be sold)?If a business unit manager controls all three of these activities there is no difficulty in Assigning profit responsibility and measuring performance.

Constraints from Corporate Management.The constraints imposed by corporate mangement can be grouped into three types.(i)those resulting from strategic considerations,especially financing decisions(ii)those resulting because uniformity is required;and those(3)those resulting from the economies of centralisation Corporate management imposes other constraints.Each business unit has a charter that specifies the marketing and /or production activities that is permitted to undertake ,and it must refrain from operating beyond its charter eventhough it sees profit opportunities in doing so.One constraint is that business must conform to corporate accounting and management control system. Some companies require large amounts of planning and reporting information from each profit centre. Other profit centres Functional Units A multibusiness co. is divided into business units that are treated,as far as practical as independent profit generating units.Within these business units,subunits may be functionally organised.In such organisation units as well as in companies that are functionally organised.

 Marketing A marketing activity can be made into a profit centre by charging it with the cost of products sold.This transfer price provides the marketing manager with the relevant information to make the optimum revenue/costs tradeoffs.Since managers of profit centres are measured on profitability,there is check on how decisions are being made.also they will be motivated to maximise profits.The profit centre should be charged with a transfer price based on standard cost and not on actual cost of products sold.

 Manufacturing The manufacturing activity is usually an expense centre,and the management of such activities is judged on performance versus standard costs and overhead budgets.Problems can occur because standard cost performance does not measure how well all of the responsibilities of the manufacturing manager are being performed.

 As a consequence,where the performance Of the manufacturing activities is measured against standard costs,quality control,production scheduling,make or buy decisions,and the setting of standards should be controlled seperately.As overall measure of the manufacturing organisation can be obtained if the organisation is made into a profit centre.One way to do this is to give the organisation credit for the selling price of the products minus the estimated marketing expenses.Such an arrangement is far from perfect,partly because many factors influencing the volume and mix of sales are outside the control of the manufacturing manager.However it works better in some cases.

 Service and support units Maintenance units,data processing units transportation units engineering units,customer service units and similar support units of an organisation Can be made into profit centres.They charge customers for services rendered,and their financial objective is to generate enough business so that their revenues equal expenses. Usually units receiving the services have the alternative of procuring them from an outside vendor if a vendor can offer services of equal quality at a lower price.

 Other organisations- A co. having branch operations that are responsible for marketing the cos products in a particular geographical area is often a natural for a profit centre type of organisation,profit measurement is an excellent motivating device. Measuring profitability There are two types of profitability measurements in a profit centre.first measure of management performance in which focus is on how well the manager is doing.Second there is measure of economic performance in which the focus is on how well the profit centre is doing as an economic activity

Types of profitability measures (i)Contribution margin (ii)Direct Profit (iii)Controllable profit (iv)Income before taxes (v)Net Income Bases of comparison Revenues Management Considerations

Transfer Pricing
One of the principal challenges in operating a decentralised system is to devise a satisfactory method of accounting for the transfer of goods and services from one profit centre to another in companies that have a significant amount of these transactions. Objectives of Transfer Prices if two or more profit centres are jointly responsible for product development,manufacturing and marketing,each should share in the revenue that is generated when the product is finally sold.The transfer price is the mechanism for distributing this revenue.The transfer pricing is not primarily an accounting tool,rather it is behaviourial tool that motivates managers to make the right decisions.

 (i)It should provide each segment with the relevant information required to determine the optimum trade-off between company costs and revenues. (ii)It should induce goal congruent decisions that is,the system should be so designed that decisions that improve business unit profits will improve company profits.(iii)It should help measure the economic performance of the individual profit centres.(iv)The system should be simple to understand and easy to administer.

 Transfer Pricing methods The fundamental principle is that the transfer price should be similar to the price that would be charged if the products were sold to outside customers or purchased from outside vendors. The ideal situation(i) competent people(ii)good atmosphere (iii)a market price(iv)Freedom to source.(v)full flow of information (vi)Negotiation If all the above condtions are present a transfer price system based on market prices would fulfill all of the objectives stated above,with no need for central administration we have to consider when one or more conditions are not present. Constraints on sourcing Limited markets Excess or shortage of industry capacity.

 Cost Based Transfer Prices How to define cost?and how to calculate profit markup? The cost Basis The usual basis is standard cost The profit mark up there are two decisions(a)On what is the profit mark up to be based?(b)what is the profit level allowed? Upstream fixed costs and Profits Transfer pricing can create a significant problem in integrated companies.Methods that companies use to mitigate this problem are described Agreement among Business units. Two step pricing charge is made for each unit sold that is equal to standard variable cost of production second a periodic charge is made that is equal to fixed costs and profit on a lump sum basis. Profit sharing (i)The product is transferred to the marketing unit at standard variable cost(ii)After the product is sold the business units share the contribution earned,which is the selling price minus the variable mfg.and marketing costs.

 Two Sets of Prices In this method manufacturing units revenue is credited at the outside sale price and the buying unit is charged the total standard costs.The difference is charged to a headquarterss a/c and eliminated when the business unit statements are consolidated.Both the buying and selling units benefit under this method.Pricing corporate services For central services that the receiving unit must accept but for which the amount of service is at least partially controllable by the unit. 2 For central services that the business unit has the discretion of using or not.

 Administration of Transfer Prices. (i)Negotiation (ii)Arbitration and conflict resolution (iii)Product classification Some companies divide products into two main classes(a)Class I includes all products for which senior management wishes to control the sourcing.These would be normally large volume of products,products wher no outside source exists, and products where for quality or secrecy reasons senior mgmt. wishes to control over manufacturing(b)Class II are all other products.These products are relatively small volume ,produced with general purpose equipment.Class II products are transferred at market prices.