©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Nine Responsibility Accounting

An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items.

Decision Making is Pushed Down Decentralization often occurs as organizations continue to grow. Decentralization

Improves quality of decisions. Encourages upper-level management to concentrate on strategic decisions. Improves productivity. Develops lower-level managers. Improves performance evaluation. Advantages

Successful implementation of responsibility accounting depends on clear lines of authority and clearly defined levels of responsibility. Organization Chart

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

Profit Center A part of the business that has control over both revenues and expenses, but no control over investment funds. Responsibility Centers Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other

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

Responsibility Reports  Prepare budgets for each responsibility center.  Prepare timely performance reports comparing actual amounts with budgeted amounts.  Measure performance of each responsibility center.

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

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

I’m in control Controllability Concept Managers should only be evaluated on revenues or costs they control. Since the exercise of control may be clouded, managers are usually held responsible for items over which they have predominant rather than absolute control.

To be of maximum benefit, responsibility reports should... Be timely. Be issued regularly. Be understandable. Compare budgeted and actual amounts of controllable items. Qualitative Reporting Features

Cost Center Profit Center Investment Center Evaluation Measures Profitability Return on investment (ROI) Residual income (RI) Cost control Quantity and quality of services Managerial Performance Measurement

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

A good example is interest you earn on your saving account Operating Income = $50 interest Operating Assets = $5,000 ROI = $50 / $5,000 = 10%

Example Green View is a lawn services company whose operations are divided into two districts. The District 1 manager controls $12,600,000 of operating assets. District 1 produced $1,512,000 of operating income during the year. The District 2 manager controls $14,200,000 of operating assets. The District 2 reported $1,988,000 of operating income for the same period.

Example What is the ROI for District 1? $1,512,000 / $12,600,000 = 12% What is the ROI for District 2? $1,988,000 / $14,200,000 = 14% Which District is performing better? District 2

Another Example Molly’s Pet Grooming has operating assets of $150,000. She has a ROI of 22%. How much is her operating incoming?

More Examples Greg’s Greenhouse has an operating income of $144,000. The ROI is 18%. What is Greg’s investment?

ROI = Operating Income Operating Assets Margin Turnover Return on Investment ROI = × Sales Operating Assets Operating Income Sales

Rose Company reports the following: Operating Income$ 40,000 Sales$ 400,000 Operating Assets$ 200,000 Let’s calculate ROI. Return on Investment

ROI = 10% × 2 = 20% Return on Investment ROI = $40,000 $400,000 × $200,000 ROI = × Sales Operating Assets Operating Income Sales

Improving R0I Three ways to improve ROI Ê Increase Sales Ë Reduce Expenses Ì Reduce Operating Assets

Rose Company was able to increase sales to $500,000 which increased operating income to $45,000. There was no change in operating assets. Rose Company was able to increase sales to $500,000 which increased operating income to $45,000. There was no change in operating assets. Let’s calculate the new ROI. Improving R0I

Rose Company increased ROI from 20% to 22.5%. Improving R0I ROI = 9% × 2.5 = 22.5% ROI = $45,000 $500,000 × $200,000 ROI = × Sales Operating Assets Operating Income Sales

ROI - A Major Drawback As division manager at Rose Company, your compensation package includes a salary plus bonus based on your division’s ROI -- 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 at Rose Company, your compensation package includes a salary plus bonus based on your division’s ROI -- 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?

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

How to Avoid Suboptimization To avoid suboptimization, many businesses base managerial evaluation on residual income. This approach measures a manager’s ability to maximize earnings above some targeted level. The targeted level of earnings is based on a minimum desired ROI.

Residual Income Operating Income – Investment charge = Residual income Investment × Desired ROI = Investment charge Investment center’s cost of acquiring investment capital

Residual Income = Operating Income – (Operating Assets * Desired ROI)

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

Residual Income Investment center’s cost of acquiring investment capital Operating Income= $25,000 – Investment charge = 20,000 = Residual income= $ 5,000 Investment = $100,000 × Desired ROI = 20% = Investment charge = $ 20,000

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

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

Let’s apply what we’ve learned: The Spokane Division of Cascade Inc. has a current ROI of 20%. The company target is 15%. The division has an opportunity to invest $4,000,000 at 18% but is reluctant to do so because its ROI will fall to 19.2%. The present investment base for the division is $6,000,000. Should the company invest?

Responsibility Accounting and the Balanced Scorecard The balance scorecard is a holistic approach to evaluating managers. Balanced Scorecard Multiple financial measures Multiple nonfinancial measures

End of Chapter Nine