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Chapter 7:

Financial Responsibility

Centers

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Agenda

1. Core elements and advantages of financial results control system

2. Different types of financial responsibility centers

3. Transfer pricing problem

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Financial results controls

 Three core elements

– Financial responsibility centers » The apportioning of accountability for financial results within the

organization

– Formal management processes (planning and budgeting) » To define performance expectations and standards for

evaluating performance

– Motivational contracts » To define the links between results and various organizational

incentives

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Advantages of financial results control systems

1) Financial objectives are paramount in for-profit firms.

2) Financial measures provide a summary measure of performance by aggregating the effects of a broad range of operating initiatives

3) Most financial measures are relatively precise and objective.

4) The cost of implementing financial results controls is often small relative to that of other forms of management control.

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Responsibility centers

 Responsibility center

» An organization unit (entity) headed by a manager with responsibility for a particular set of inputs and/or outputs

 Financial responsibility center » A responsibility center in which the manager’s

responsibilities are defined primarily in financial terms

» Four types: revenue center, cost center, profit center, and investment center

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1. Revenue centers (RCs)  Managers of revenue centers are held accountable for

generating revenues (a financial measure of outputs)

» For example, sales departments in commercial organizations » For example, fundraising managers in not-for-profit organizations

 No formal attempt is made to relate inputs (measured as expenses) to outputs

» However, most revenue center managers are also held accountable for some expenses (e.g., salespeople’s salaries and commissions)

» But, still they are not profit centers because:

 Such costs are only a small fraction of the revenues generated  Revenue centers are not charged for the costs of the goods

they sell

 If sales are not “equally endowed”, then revenue responsibility will not necessarily lead to the most profitable sales

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2. Cost centers (CCs)  Managers of cost centers are held accountable for some

elements of cost (a financial measure of the inputs consumed by the responsibility center)

» “Standard” or “engineered” cost centers (ECC)  Inputs and outputs can be measured in monetary terms

 There is a ‘causal’ relationship between inputs and outputs

– For example, manufacturing departments

» “Managed” or “discretionary” cost centers (DCC)  Outputs produced are difficult to measure

 Relationship between inputs and outputs is hard to establish

– For example, R&D, human resources departments

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Control in cost centers

 Engineered cost centers (ECC)

» Standard cost vs. actual cost

 Analysis of the cost of inputs that should have been consumed in producing the output vs. the cost that was actually incurred

» Additional controls

 Volume produced, quality, etc.

 Discretionary cost centers (DCC)

» Ensuring that managers adhere to the budgeted costs while successfully accomplishing the tasks of their center

» Subjective, non-financial controls

 For example, quality of service provided

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3. Profit centers (PCs)  Managers of profit centers are held accountable for

generating profits (a financial measure of the difference between revenues and costs)

 As a measure of performance, profit is … » Comprehensive

 That is, it incorporates many aspects of performance

» Unobtrusive

 That is, the profit center manager makes the revenue/cost tradeoffs

 Has the manager significant influence over both revenues and costs?

» Charge standard cost of goods sold to sales-focused entities

» Assign revenues to cost-focused entities

» Pseudo profit centers

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Measuring “profit” in profit centers

Revenue

Cost of goods sold

Gross margin

Advertising + promotion

Research + development

Profit before tax

Income tax

Profit after tax

Gross Margin Center

Incomplete Profit Center

Before-tax Profit Center

Complete Profit Center

   

  

 

 

Note:  signifies that the responsibility center manager is held accountable for that financial statement line item. Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ: Prentice Hall, 1998), p. 306

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4. Investment centers (ICs)  Managers of investment centers are held accountable for

the accounting returns (profits) and the investment made to generate those returns

» Absolute differences in profits are not meaningful if the various organizational entities use different amounts of resources.

» Varying definitions: ROI, ROE, RONA, ROCE, ROTC, RAROC.

 In fact, managers have two performance objectives

» Generate maximum profits from the resources at their disposal

» Invest in additional resources only when such an investment will produce an adequate return

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Organization structure

Administrative and Financial

Vice Presidents (DCC)

President (IC)

Group Vice President

(IC)

SBU Manager (PC)

SBU Manager (PC)

SBU Manager (PC)

SBU Manager (PC)

Group Vice President

(IC)

Procurement (ECC)

Manufacturing (ECC)

Sales (RC)

Divisional Staff Functions (DCC) … … …

…

…

…

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Transfer pricing

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Transfer pricing- Definition

 The price at which products or services are transferred between profit centers within the same firm

– It affects the revenues of the producing profit center (PC), the costs of the buying PC, and, hence, the profits of both entities

 Purposes – Provide proper economic signals so that PC managers make

good economic decisions from a corporate standpoint

– Provide information for evaluating PC performance

– Purposely move profits between company entities/locations » For example, for tax purposes, or in joint-ventures

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1. Market-based transfer prices

 Where a (“perfectly” competitive) external market exists

 Managers of both the selling and buying PC will make decisions that are optimal from a corporate perspective, and reports of their performances will provide good information for evaluation purposes

 Actual price, which is charged to external customers, listed price of a similar product, or the price a competitor is offering (bid price)

– Deviations can be allowed that reflect differences between internal and external sales:

» Savings in marketing, selling, and collecting costs

» Differences in quality standards, special features, or special services provided

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2. Marginal cost transfer prices

 It excludes upstream fixed costs and profits and, hence, the marginal costs remain visible for the PC that finally sells to outside customers

 It provides poor information for evaluation purposes » The selling PC incurs a loss » The profits of the buying PC are overstated

 Rarely used in practice

 Variation: Marginal cost + lump-sum fee » The marginal cost of the transfer remains visible

» The selling PC can recover its fixed cost and a profit margin through the lump-sum fee

» Problem: estimation of capacity to “reserve” for internal sales

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3. Full cost transfer prices

 Popular in practice

 Relatively easy to implement

» Firms have cost systems in place to calculate the full cost of production

» But, full costs rarely reflect actual, current costs of producing the products because of financial accounting conventions (e.g., depreciation) and arbitrary overhead cost allocations

 There is no incentive for the selling PC to transfer internally since there is no profit margin

 The profit of the selling PC is understated, the profit of the buying PC is overstated.

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4. Full cost + markup transfer prices

 It allows the selling PC to earn a profit on internally transferred products/services

 Crude approximation of the market price in cases where no competitive external market price exists

– Such transfer prices, however, are not (quite) responsive to market conditions

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5. Negotiated transfer prices

 Transfer prices are negotiated between the selling and buying PC managers themselves

» Both PC managers should have some bargaining power (i.e., some possibilities to sell or source outside)

» The outcome is often not economically optimal, but rather depends on the negotiating skills of the managers involved

 It is costly (management time), accentuates conflicts between PC managers, and often requires corporate management intervention

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Chapter 8: Planning and Budgeting

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 Three core elements

– Financial responsibility centers » The apportioning of accountability for financial results within

the organization

– Formal management processes » Planning and budgeting to define performance expectations

and standards for evaluating performance

– Motivational contracts » To define the links between results and various organizational

incentives

Financial results controls

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Planning and budgeting

 Produce written plans that specify:

– Where the organization wishes to go (objectives)

– How it intends to get there (strategies)

– What results should be expected (performance targets)

 Purposes of planning and budgeting processes 1) To engage in planning and long(er)-term forward-thinking

2) To achieve coordination (top-down, bottom-up, sideways)

3) To facilitate top management oversight

4) To establish “challenging-but-achievable” performance targets (motivation and evaluation)

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Planning cycle

Operational Budgeting

• Relatively broad processes of thinking about the missions, goals, and strategies

• Normally a top-management process

Strategic Planning

• Identification of specific action programs to be implemented over the next few years and specification of the resources each will consume

• It involves managers at different levels (top-down/bottom-up)

Programming

/Capital Budgeting

• Short-term financial planning • Budgets match the organization’s

responsibility structure • Emphasis on quantitative dataIn

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Characteristics of a budget

 It is usually stated in monetary terms

 It generally covers a period of one year

 It contains an element of management commitment, that is, the managers agree to accept the responsibility for attaining the budgeted objectives

 The budget is approved by an authority higher than the budgetee

 Once approved, the budget can be changed only under specified conditions

 Periodically, actual financial performance is compared to budget and variances are analyzed and explained

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Budgeting and management control

 Budgeting involves setting targets that are commonly used as standards against which to evaluate performance – results controls

 Planning and budgeting processes involve formal reviews of plans and include the actions that are felt to be good for the organization to take – action controls

 Planning and budgeting processes provide the needed information for decision making to the relevant managers – personnel controls

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The budget preparation process

Budget Department

Budget Committee

Business Managers

3. Negotiation

4. Approval

Top-Down

Bottom-Up

The budgeting process takes about 4 months in most firms

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Types of financial performance targets

1) Model-based (engineered) / historical / negotiated

2) Fixed / Flexible

– Should managers be held accountable for achieving their plans regardless of the business conditions they face?

– Relative performance targets

3) Internally / externally-derived

– Target costing

– Benchmarking

Information asymmetry

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Common issues in financial performance target

1) Budget Participation: the appropriate amount of influence to allow subordinates in setting targets.

2) Budget Target Difficulty: the appropriate amount of challenges in a target.

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Issue 1: Budget participation

 Top-down / bottom-up budgeting

» Bottom-up: allowing the budgetees to both be involved and have influence over setting the budget has several benefits:

1) commitment to achieve the target

2) information sharing

3) cognitive

» as well as potential for slack, bias, conservatism, …

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Issue 2: Budget target difficulty

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Challenging but achievable

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Issue 2: Budget target difficulty (con’d)

In theory (lab experiments):

“Good targets” are about 25–40% achievable

Target Performance

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In practice (field research)

Targets are about 80–90% achievable

Target Performance

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Issue 2: Budget target difficulty (cont’d)

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Effective vs. ineffective management teams

A Target

Performance

P ro

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Issue 2: Budget target difficulty (cont’d)

Effective, hard-working managers

Ineffective, lazy managers

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Low vs. high uncertainty

Target Performance

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Issue 2: Budget target difficulty (cont’d)

Low uncertainty

High uncertainty

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Challenging but achievable …

 To minimize dysfunctional management actions

» Myopic behavior, data manipulation

 To increase manager’s commitment to budget targets

 To reduce the cost of organizational interventions

» Management-by-exception

 To protect against the cost of optimistic revenue projections

» Over-commitment of resources

 To create a “winning” atmosphere and positive attitude

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“Beyond Budgeting”?

 Some “principles” – Goals

» Set relative goals for continuous improvement; not fixed performance contracts – Rewards

» Reward success based on relative performance; not on meeting fixed targets – Planning

» Make planning a continuous and inclusive process; not a top-down annual event – Coordination

» Coordinate interactions dynamically; not through annual planning cycles – Resources

» Make resources available as needed; not through annual budget allocations – Controls

» Base controls on relative indicators and trends; not on variances against plan

 Applicability in practice? Effectiveness? Problems?

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