Chapter 8 Responsibility Centres Learning Objectives Lead C
Chapter 8 Responsibility Centres
Learning Objectives Lead C 1: Analyse the performance of responsibility centres and prepare reports Component C 1): a) Analyse the performance of cost centres, revenue centres, profit centres & investment centres b) Prepare reports for decision-making • Objectives of each responsibility centre. • Controllable and uncontrollable costs and revenue. • Costs variability, attributable costs and revenue and identification of appropriate measures of performance. • Use of Data analytics in performance management of responsibility centres. • Key Performance indicators (e. g. profitability, liquidity, asset turnover, return on investment and economic value
Session Content Cost Centres, Profit Centres and Investment Centres Organisation Structure Residual Income ROI Behavioural Issues
Decentralization/ Divisionalisation Decentralisation seeks to overcome the problem of managing a large organisation by creating a structure based on several autonomous decision-making units. Objective 1. 2. 3. 4. Promote goal congruence Increase motivation of management Reduce head office bureaucracy Provide better training for junior and middle management Problems Divisions make decisions in their own best interests, but which are not good from the company point of view. The problem is overcome by introducing a suitable system of performance evaluation.
Objectives of Performance Evaluation 1. Promote goal congruence 2. Encourage initiative and motivation 3. Provide feedback to management 4. Encourage long-term rather than short-term views These objectives can only be achieved with the introduction of responsibility centres. - Cost Centres - Profit Centres - Investment Centres In responsibility accounting, a specific manager is given the responsibility for a particular aspect of the budget, and within the budgetary control system, he or she is then made accountable for actual performance.
Objectives of Performance Evaluation In responsibility accounting, a specific manager is given the responsibility for a particular aspect of the budget, and within the budgetary control system, he or she is then made accountable for actual performance. The area of operations for which a manager is responsible is called a responsibility centre. Each cost centre, profit centre and investment centre should have its own budget, and its manager should receive regular budgetary control information relating to the centre, for control and performance measurement purposes. If the principle of controllability is applied, a manager should be made responsible and accountable only for the costs (and revenues) that he or she is in a position to control.
Performance Evaluation An organisation should have certain targets for achievement. Targets can be expressed in terms of key metrics. It is a basis for analysing performance (both budgeted and actual). Actual performance should then be assessed in comparison with the targets. The term ‘key performance indicators’ might be used.
Performance Evaluation Key areas of financial performance are: • Profitability • ROCE = Profit/Turnover x Turnover/Capital Employed = Profit/Capital Employed • Liquidity • Current Asset – Quick Ratio • Asset turnover • Working Capital Ratios • Asset turnover • Shortcoming of Financial Indicators • Non-Financial Performance Indicators
Divisional Performance Measurement ROCE RI EVA = = = NOPAT – Earning Before Profit – Imputed Capital Charge Interest and Tax Interest Charge x 100 Capital Employed Imputed Interest Charge = Capital Employed X Cost of Capital
ROCE Advantages Disadvantages Widely used and accepted Dysfunctional behaviour when projects with lower ROI are turned away Enables comparisons Different accounting policies between divisions and can confuse comparisons companies of different sizes Can be broken down into ROCE increases artificially secondary ratios for more with age of assets, thus detailed analysis discouraging investment
Example 1 Nielsen Ltd has 2 divisions with the following information: Division A Division B $ Profit 90, 000 Capital Employed 300, 000 100, 000 ROCE 30% 10, 000 10% Division A has been offered a project costing $100, 000 and giving returns of $20, 000. Division B has been offered a project costing $100, 000 and giving returns of $12, 000. The company's cost of capital is 15%. Divisional performance is judged on ROCE and the ROCErelated bonus is sufficiently high to influence the managers' behaviour. 1. What decisions will be made by management if they act in the best interests of their division (and in the best interest of their bonus)?
Example 1 2. What should the managers do if they act in the best interests of the company as a whole?
ROI Advantages Disadvantages Reduces ROI’s problem of rejecting Does not facilitate comparisons projects with an ROCE in excess of between divisions the company’s target but lower that the division’s current ROCE The cost of financing a division is Does not relate the size of a brought home to divisional division’s profit to the assets managers employed in order to obtain that profit. Can be broken down into secondary ratios for more detailed analysis
Residual Income Advantages Disadvantages It reduces ROCE's problem of rejecting Does not facilitate comparisons projects with an ROCE in excess of the between divisions company's target, but lower than the division's current ROCE. The cost of financing a division is Does not relate the size of a division's brought home to divisional managers profit to the assets employed in order to obtain that profit
Example 2 An investment centre has net assets of $800, 000, and made profits before interest of $160, 000. The notional cost of capital is 12%. An opportunity has arisen to invest in a new project costing $100, 000. The project would have a four-year life, and would make cash profits of $40, 000 each year. Required: 1. What would be the average ROI with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on ROI in Year 1? 2. What would be the average annual residual income with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on residual income in Year 1?
EVA Similar to RI, but accounting profit is adjusted for economic depreciation and advertising / Development costs; and net assets are valued at replacement cost ECONOMIC PROFIT (Net Operating Profit After Tax) $X Less : Capital charge (net assets x cost of capital) ($X) EVA $X Advantages of EVA • A performance measure that attempts to put a figure to the increase, or decrease, which should have arisen during a period from the operations of a company or individual divisions within a company. • Can be measured for each financial reporting period. • Based on economic profit and economic values of assets, not accounting profits and asset values. • Easily understood by non-accountants.
Example 3 A division has a reported annual profit of $27 m. This was after charging $6 m for the development and launch costs of a new product which is expected to have a life of 3 years. The division has a risk adjusted cost of capital of 10% per annum, but it has a large bank loan, which incurs annual interest charges of 8%. The net book value of the division's net assets is $85 m. The replacement cost of the assets is estimated to be $96 m. Ignore the effects of taxation. Calculate the division's EVA.
Reports for Decision Making Report visualisation through the use of data analytics in performance management is the process of presenting report formats that represent data & information in a pictorial or graphical format. In today’s , modern business environment , the volume of data is far larger than ever, therefore the art of report visualisation has become increasingly important & as such for management accountant our role is to support effective decision making by presenting relevant, timely and accurate information in a manner that enables informed dialogue and decision making • Five Principles for effective report visualisation. 1. Ensure data is optimised for report visualisation 2. The relevant visualisation tool must be applied 3. An appropriate report layout must be chosen 4. The reader experience must be optimised 5. Visualisation to the appropriate delivery channel must be optimised
Chapter 9 Alternative Measures of Performance
Learning Objectives Lead C 2: Discuss various approaches to the performance and control of organisations. Component C 2): a) Discuss budgets and performance evaluation b) Discuss other approaches to performance evaluation • Benchmarking (internal & external) • Non-financial performance indicators • Balanced Scorecard.
Budgetary Control • We need to distinguish between a fixed and a flexible budget • A fixed budget is not particularly useful for control as it is predominantly used in the planning stage of budget preparation whilst a flexed budget recognises cost behaviour patterns at different activity levels hence its usefulness for control as the original(fixed) budget can be flexed to show the costs and revenues for the actual level of activity. • Its also important we are able so separate controllable & uncontrollable costs as to enable us to assess the performance of managers. The aim under a responsibility accounting system will be to assign and report on the cost to the person having primary responsibility
Planning and operational variances
Shortcomings of financial indicators The use of traditional financial performance metrics is widespread, but the practice has its problems. • They only tell what has happened over a limited period in the immediate past. • They give no indication of what is going to happen in the future • They are susceptible to manipulation and to the choice of accounting policy on matters such as depreciation and inventory valuation. • They do not relate to the strategic management of the business and may include ‘short-termism
Non-Financial Performance Indicators • ‘ Measures of performance based on non-financial information that may originate in, and be used by, operating department to monitor and control their activities without any accounting input’ (CIMA) • Financial performance appraisal often reveals the ultimate effects of operational factors and decisions but non-financial indicators are needed to monitor causes. • Critical success factors often non-financial • Stakeholder objectives may also be non-financial
Planning for NFPs usually more complex. Not for Profit Organisations • Multiple objectives • • • Difficult to quantify objectives Conflicts between stakeholders Difficult to measure performance Different ways to achieve the same objective Objectives may be politically driven 3 E Concept (Value for money (VFM) Concept) • Effectiveness • Efficiency • Economy
Benchmarking Types Benchmarking – is a technique that is increasingly being adopted as a mechanisms for continuous improvement. • A continuous process of measuring a firm’s products, services and activities against other best-performing organisations, either internal or external to the firm. • Internal - within the same organisation • Competitive - direct competitors • Functional - a similar function in other organisations • Strategic - aimed at gaining strategic change
Balanced Scorecard Financial perspective To succeed financially, how should we appear to our shareholders? Customer perspective To achieve our vision, how should we appear to our customers? Vision and strategy Learning and growth perspective To achieve our vision, how will we sustain our ability to change and improve? Internal business process perspective To satisfy our shareholders and customers, what business processes must we excel at?
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