Chapter Nine Responsibility Accounting

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc. 2006

Responsibility Accounting

An accounting system that provides information . . . Relating to the responsibilities of individual managers.

To evaluate managers on controllable items.

Decentralization Middle Management Top Management

Decentralization often occurs as organizations continue to grow.

Middle Management Supervisor Supervisor Supervisor Supervisor

Decision Making is Pushed Down

Decentralization

Improves quality of decisions.

Improves productivity.

Improves performance evaluation.

Develops lower-level managers.

Advantages

Encourages upper-level management to concentrate on strategic decisions.

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

Board of Directors Vice President of Finance President Vice President of Operations Store Manager Department Manager Vice President of Marketing

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

Responsibility Centers Profit Center A part of the business that has control over both revenues and expenses, but no control over investment funds.

Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other

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

Corporate Headquarters

Responsibility Reports  Prepare budgets for each responsibility center.

 Measure performance of each responsibility center.

 Prepare timely performance reports comparing actual amounts with budgeted amounts.

Management by Exception and Degree of Summarization 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

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.

Controllability Concept

Managers should only be evaluated on revenues or costs they control.

I’m in 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.

Qualitative Reporting Features To be of maximum benefit, responsibility reports should . . .

 Be timely .

   Be issued regularly .

Be understandable .

Compare budgeted and actual amounts of controllable items.

Managerial Performance Measurement

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

Return on Investment Return on investment is the ratio of income to the investment used to generate the income.

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?

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

Margin Turnover

Return on Investment Rose Company reports the following: Operating Income Sales Operating Assets $ 40,000 $ 400,000 $ 200,000

Let’s calculate ROI.

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

Improving R0I  Reduce Expenses  Increase Sales  Reduce Operating Assets

Three ways to improve ROI

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

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 would you invest in this project?

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!

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 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.

Let’s calculate residual income.

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

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?

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