Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Chapter 12 Responsibility Centers and Financial Control

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Chapter Objectives: To be able to: 1. Describe the form and nature of variance analysis and apply its basic insights. 2.Explain why organizations use responsibility centers. 3.Identify the issues to consider and basic tools to use in assessing the performance of a responsibility center. 4.Describe the common forms of responsibility centers. 5. Assess the issues and problems created by revenue and cost interactions in evaluating the performance of an organization unit. 6.Identify the transfer-pricing alternatives available to organizations and the criteria for choosing a transfer-pricing alternative. 7.Use return on investment and economic value added as financial control tools. 8.Identify the limitations of financial controls.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Financial Control and Variance Analysis Purpose: Monitor, assess and improve operations Variance analysis:The set of procedures used by managers to help them understand the source of differences (variances) between actual and budgeted costs. Master budget:The document that forecasts revenues and expenses during the next operating period. Flexible budget:The forecast of the projected level of cost given the volume and mix of activities undertaken.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Financial Control and Variance Analysis First-level variances:For cost items, the difference between the actual and master budget costs for that cost item. Second-level variances:The planning variance and flexible budget variance, which combined are the first-level variance. Exhibit 12-1, 12-2, 12-3, 12-4, 12-5, 12-6, 12-7, 12-8, 12-9

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Decentralization versus Centralization CentralizationReserving decisionmaking power for senior management levels. DecentralizationRefers to the authority that local-division managers have in order to make their own decisions without having to seek higher approval on various business operations. Discussion of advantages and disadvantages. Conditions necessary for effective decentralization: 1. Employees must be given, and must accept, the authority and responsibility to make decisions. 2.Employees must have the training and skills they need to accept the decision- making responsibility. 3.The organization must have a system in place that guides and coordinates the activities of decentralized decision makers.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Controlling Operations Using Financial Control Operations controlThe process of providing feedback to employers and their managers about the efficiency of activities being performed. Financial controlA process used to assess an organizations financial success by measuring and evaluating its financial outcomes. The Liz Clairborne case as an example of the difference between financial control and operations control, page 519. Choosing between Operations and Financial control, page 519.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 1 of 7 DefinitionAn organization unit for which a manager is made responsible. ”A responsibility center is like a small business, and its manager is asked to run the small business to promote the best interests of the larger organization”. Controlling the activities of responsibility centers requires measuring the nonfinancial elements of performance, such as quality and service that create financial results. Controllability principleStates that the manager of a responsibility center should be assigned responsibility only for the revenues, costs, or investment that responsibility center personnel control.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 2 of 7 Responsibility center types (exhibit 12-15): Cost CenterResponsibility centers in which employees control costs but do not control revenues or investment level. Revenue CenterA responsibility center in which members control revenues but do not control either the manufacturing or the acquisition cost of the product or service they sell or the level of investment made in the responsibility center. Profit CenterA responsibility center in which managers and other employees control both the revenues and the costs of the product or service they deliver. Investment CenterA responsibility center in which the manager and other employees control revenues, costs, and the level of investment in the responsibility center.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 3 of 7 Cost Center How to perform financial control in a cost center:  Cost-variance analysis (master budget, flexible budget, use and cost-price variances)  Establish trend measurement tools (examples: graph plots, indexes, efficiences)  Non-financial measures such as quality, response time, cycle time, ability to meet production schedules, ethical and environmental commitments etc. Examples from Arla Foods.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 4 of 7 Revenue Center Subjects to consider when determing how to perform financial control in a revenue center:  Quantity sold  Prices obtained  Product mix  Inventory level  Promotional activities  perhaps deduct traceable costs such as salaries, advertising cost and selling costs

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 5 of 7 Profit Center Subjects to consider when determining how to perform financial control in a profit center:  There’s a risk that financial performance measure may contain performance such as: 1. Conditions that no one in the organization can control. 2. Poor corporate decisions. 3. Poor local conditions.  Measures should include nonfinancial measures that better describe performance influenced by the managers assigned responsibility.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 6 of 7 Investment center Subjects to consider when determining how to perform financial control in an investment center:  There’s a risk that the financial performance measure return-on-investment may contain performance such as: 1. Conditions that no one in the organization can control. 2. Poor corporate decisions. 3. Poor local conditions.  How to include jointly used assets such as cash, building and equipment?  How to include jointly created assets, such as cash, building and equipment?  What cost should be used? Historical cost, net book value, replacement cost or net realizable value?

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Responsibility Centers, page 7 of 7 How to determine what is considered good or bad numbers  Past performance  Comparable organizations (peer groups)  Other measurements

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Transfer Pricing, page 1 of 4 DefinitionThe set of rules an organization uses to assign the prices to products transferred between internal responsibility centers. Four approaches to transfer pricing (exhibit 12-21): 1.Market-based transfer prices 2.Cost-based transfer prices 3.Negotiated transfer prices 4.Administered transfer prices PurposeTo motivate the decision maker to act in the organizations best interests. The purpose of producing management accounting numbers is to motivate desirable behavior regarding managers planning, decision making and resource allocation activities.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Transfer Pricing, page 2 of 4 Market-Based Transfer Prices If external markets exist for the product or service, the market price is an appropriate basis for internal transfer of goods or services. In addition, if the buying division has the option to by goods or services outside the organization, or similarly the selling division can sell its products or services outside the organization, that speaks for Market-Based Transfer Prices. If an external clear market price does not exist using Market-based Transfer Prices could be very dangerous and cause wrong decisions to be made (sub-optimization).

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Transfer Pricing, page 3 of 4 Cost-Based Transfer Prices When no market price is available, a very common transfer price is cost-based. The most typical ones are at: Variable cost Variable cost + a percent markup Full cost Full cost + a percent markup One could argue that any cost-based transfer price other than marginal cost leads organization members to choose a lower than optimal level of transactions, causing an economic loss to the overall organization. Can marginal costs at all be computed as a standard pricing? Proper economic guidance when operations are capacity constrained? Is it more important to measure exact performance than to apply a fair and consistent measurement of performance?

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Transfer Pricing, page 4 of 4 Negotiated Transfer Prices In the absence of market prices, a negotiated transfer price may be chosen since it reflects the controllability perspective inherent in responsibility centers, since each division is ultimately responsible for the transfer price that it negotiates. Administered Transfer Prices Organizations often use administered prices when a particular transaction occurs frequently. Is typically set as market price less x% or full cost plus x%.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Transfer Pricing, page 4 of 4 Negotiated Transfer Prices In the absence of market prices, a negotiated transfer price may be chosen since it reflects the controllability perspective inherent in responsibility centers, since each division is ultimately responsible for the transfer price that it negotiates. Administered Transfer Prices Organizations often use administered prices when a particular transaction occurs frequently. Is typically set as market price less x% or full cost plus x%.

Management Accounting Chapter 12 - Responsibility Centers and Financial Control Management Accounting Chapter 12 - Responsibility Centers and Financial Control Department of Accounting Criticism to Financial Control Financial control may be an ineffective control scorecard for three reasons: 1. Focus on measures that do not measure the organizations other important attributes, such as product quality, the speed at which the organizations develops and makes products, customer service or the ability to provide a work environment that motivates employees. 2.Measures the financial effect of the overall level of performance achieved on the critical success factors and it ignores the performance achieved on the individual critical succes factors. The argument is that effective control begins with measuring and managing the elements of processes that create financial returns, rather than measuring the financial returns themselves. 3.Is usually oriented towards short-term profit performance.