Responsibility Accounting

1. Responsibility Accounting Chapter 9

2. Responsibility Accounting An accounting system thatprovides information . . . Relating to theresponsibilities ofindividual managers. To evaluatemanagers oncontrollable items.

3. Decentralizationoften occurs asorganizationscontinue to grow. Decentralization Decision Making is Pushed Down

4. Decentralization Promotes betterdecision making. Improvesproductivity. Improvesperformanceevaluation. Developslower-levelmanagers. Advantages Allows upper-level management toconcentrate on strategic decisions.

5. Responsibility Reports Responsibility Reports Prepared for each individual who has control over revenue or expense items Cost

6. Responsibility Reports • Prepare budgets for each responsibility center. • Measure performance ofeach responsibility center. • Prepare timely performance reportscomparing actual amounts with budgeted amounts.

7. The Controllability Concept Successful implementation of responsibility accounting depends on clear lines of authority and clearly defined levels of responsibility.

8. Management by Exception and the Degree of Summarization Amount of detail varies according to level in organization. Departmentmanager receives detailed reports. Store manager receives summarized information from each department.

9. Management by Exception and the Degree of Summarization Amount of detail varies according to level in organization. Management by exception Upper-level management does not receive operating detail unless problems arise. The vice president of operations receives summarized information from each store.

10. Qualitative Reporting Features To be of maximum benefit, responsibility reports should . . . • Betimely. • Be issued regularly. • Be understandable. • Compare budgetedand actual amounts.

11. Responsibility Centers • A responsibility center is the point in an organization where the control over revenue or expense is located, e.g. division,department or a single machine. • A responsibility center may be divided into three categories • cost • profit • investment

12. Types of Responsibility Centers Cost Center A business segment that incurs expenses but does not generate revenue. Cost

13. Types of Responsibility Centers Profit Center A part of the business that has control over bothrevenues and expenses, but no control over investment funds. Revenues Sales Interest Other Expenses Manufacturing Commissions Salaries Other

14. Types of Responsibility Centers Investment Center A profit center where management also makes capital investment decisions. Corporate Headquarters

15. Evaluation Measures Cost control Quantity and qualityof services Cost Center Profit Center Profitability Investment Center Return on investment (ROI) Residual income (RI) Measuring Managerial Performance

16. Net Income Investment ROI = Return on Investment Return on investment is the ratio of income to the investment used to generate the income.

17. Net Income Sales Sales Investment Return on Investment Net Income Investment ROI = ROI = × Margin Turnover

18. Return on Investment Cola Company reports the following: Net Income $ 30,000 Sales $ 500,000 Investment $ 200,000 Let’s calculate ROI.

19. ROI = ROI = × × Net Income Sales $30,000 $500,000 Sales Investment $500,000 $200,000 Return on Investment ROI = 6% × 2.5= 15%

20. Improving R0I • Reduce Expenses Three ways to improve ROI • Increase • Sales • Reduce Investment

21. Improving R0I • Cola Company’s manager was able to increase sales to $600,000 which increased net income to $42,000. • There was no change in investment. Let’s calculate the new ROI.

22. ROI = ROI = × × Net Income Sales $42,000 $600,000 Sales Investment $600,000 $200,000 Improving R0I ROI = 7% × 3= 21% Cola Company increased ROI from 15% to 21%.

23. ROI - A Major Drawback • As division manager at Cola Company,your compensation package includesa salary plus bonus based on your division’sROI -- the higher your ROI, the bigger your bonus. • The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. • You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager would you invest in this project?

24. ROI - A Major Drawback Gee . . . I thought we were supposed to do what was best for the company! As division manager, I wouldn’t invest in that project because it would lower my pay!

25. Residual Income Earned Income – Investment charge = Residual income Investment ×Desired ROI = Investment charge Investment center’scost of acquiring investment capital

26. Residual Income • Cola Company has an opportunity to invest $100,000 in a project that willearn $25,000. • Cola Company has a 20 percent desired ROI and a 30 percent ROI on existing business. Let’s calculate residual income.

27. Residual Income Investment = $100,000 ×Desired ROI = 20% = Investment charge = $ 20,000 Investment center’scost of acquiring investment capital

28. Residual Income Earned Income = $25,000 – Investment charge = 20,000 = Residual income = $ 5,000 Investment = $100,000 ×Desired ROI = 20% = Investment charge = $ 20,000 Investment center’scost of acquiring investment capital

29. Residual Income • As a manager at Cola Company, would you invest the $100,000 ifyou were evaluatedusing residual income? • Would your decision be different if you were evaluated using ROI?

30. Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

31. Transfer Pricing Let’s change topics!

32. Transfer Pricing The amount charged when one divisionsells goods or services to another division. Batteries Battery Division Auto Division

33. Transfer Pricing The transfer price affects the profit measure forboth the selling division and the buying division. A higher transferprice for batteriesmeans . . . Battery Division Auto Division greater profits forthe battery division. lower profits forthe auto division.

34. Transfer Pricing The ideal transfer price allowseach division manager to makedecisions that maximize thecompany’s profit, whileattempting to maximize thedivision’s profit.

35. Setting Transfer Prices Market-based transfer prices arepreferred because they promote efficiency and fairness. • When market prices are not available,companies may use . . . • Cost-based prices • Negotiated prices

36. Negotiated Transfer Price A system where transfer prices are arrived at through negotiation between managers of buying and selling divisions. Excessive managementtime may be used in thenegotiation process. May not be in thebest interest ofthe company.

37. Cost-Based Transfer Prices Cost-based transfer prices are theleast desirable because the incentiveto control cost is diminished. When used, cost-based transfer prices . . . • Are either variable cost or full cost. • Should use standard rather than actual costs.

38. Setting Transfer Prices Conflicts may arise between the company’s interests and an individual manager’s interests when transfer-price-based performance measures are used.

39. End of Chapter 9 Let’s transfer some ofyour capital to me sothat my rate of returnwill be higher!