Management Control Systems

Chapter 4
Responsibility Centers: Revenue and Expense Centers
Responsibility Centers

 A responsibility center is an organization unit that is headed by a manager who is

responsible for its activities.
 Two different types of responsibility centers: revenue centers and expense
centers.
 Expense centers can be divided into two categories: engineered expense centers
and discretionary expense centers.
 Three of the most common types of discretionary expense centers: administrative
and support centers, research and development (R&D) centers, and marketing
centers.
Nature of Responsibility Centers

 A responsibility center exists to accomplish one or more purposes, termed its

objectives.
 The core operation of every responsibility center: Responsibility centers receive
inputs, performs its particular function using working capital, and transforming its
inputs into outputs.
 The products (i.e., goods and services) produced by a responsibility center may
be furnished either to another responsibility center, where they are inputs, or to
the outside marketplace, where they are outputs of the organization as a whole.
 Revenues are the amounts earned from providing these outputs.
Relation between Inputs and Outputs

 Management is responsible for ensuring the optimum relationship between inputs

and outputs.
 In some centers, the relationship is causal and direct.
 In many situations, however, inputs are not directly related to outputs.
Measuring Inputs and Outputs

 Much of the input that responsibility centers use can be stated as physical
measurements.
 Cost is a monetary measure of the amount of resources used by a responsibility
center.
 Inputs are resources used by the responsibility center.
 It is much easier to measure the cost of inputs than to calculate the value of
outputs.
Efficiency and Effectiveness

 Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input.
Responsibility Center is more efficient (1) if it uses fewer resources but produces the same
output or (2) if it uses the same amount of resources but produces a greater output.
 Effectiveness is determined by the relationship between a responsibility center’s output
and its objectives. The more this output contributes to the objectives, the more effective the
unit.
 Efficiency and effectiveness are not mutually exclusive; every responsibility center ought
to be both efficient and effective.
 A responsibility center is efficient if it does things right, and it is effective if it does the
right things.
Types of Responsibility Centers

 There are four types of responsibility centers, classified according to the nature of the
monetary inputs and/or outputs that are measured for control purposes: revenue centers,
expense centers, profit centers, and investment centers.
 In revenue centers, output is measured in monetary terms.
 In expense centers, inputs are so measured.
 In profit centers, both revenues (output) and expenses (input) are measured.
 In investment centers, the relationship between profit and investment is measured.
Revenue Centers

 In a revenue center, output (i.e., revenue) is measured in monetary terms, but no

formal attempt is made to relate input (i.e., expense or cost) to output.
 If expense was matched with revenue, the unit would be a profit center.
 Typically revenue centers are marketing/sales units that do not have authority to
set selling prices and are not charged for the cost of the goods they market.
 Actual sales or orders booked are measured against budgets or quotas, and the
manager is held accountable for the expenses incurred directly within the unit, but
the primary measurement is revenue.
Expense Centers

Expense centers are responsibility centers whose inputs are measured in monetary
terms, but whose outputs are not. There are two general types of expense centers:
engineered and discretionary.
 Engineered costs are those for which the “right” or “proper” amount can be
estimated with reasonable reliability—for example, a factory’s costs for direct
labor, direct material, components, supplies, and utilities.
 Discretionary costs (also called managed costs) are those for which no such
engineered estimate is feasible.
1. Engineered Expense Centers

Engineered expense centers have the following characteristics:

 Their input can be measured in monetary terms.
 Their output can be measured in physical terms.
 The optimum dollar amount of input required to produce one unit of output can be
determined.

 Engineered expense centers are usually found in manufacturing operations.

 Output multiplied by the standard cost of each unit produced measures what the finished
product should have cost.
 The difference between the theoretical and the actual cost represents the efficiency of the
expense center being measured.
2. Discretionary Expense Centers

 Discretionary expense centers include administrative and support units (e.g., accounting,
legal, industrial relations, public relations, human resources), research and development
operations, and most marketing activities.
 The output of these centers cannot be measured in monetary terms.
 The term discretionary reflects management’s decisions regarding certain policies.
 In a discretionary expense center, the difference between budget and actual expense is not
a measure of efficiency. Rather, it is simply the difference between the budgeted input and
the actual input, and does not incorporate the value of the output.
General Control Characteristics
Budget Preparation - Discretionary Expense Centers

The work done by discretionary expense centers falls into two general categories:
 Continuing work is done consistently from year to year, such as the preparation of
financial statements by the controller’s office.
 Special work is a “one-shot” project—for example, developing and installing a profit-
budgeting system in a newly acquired division.

A technique often used in preparing a discretionary expense center’s budget is management by

objectives, a formal process in which a budgetee proposes to accomplish specific jobs and
suggests the measurement to be used in performance evaluation.
General Control Characteristics
Budget Preparation - Discretionary Expense Centers

The planning function for discretionary expense centers is usually carried out in one of two
ways:
 Incremental Budgeting
In this model, the discretionary expense center’s current level of expenses is taken as a starting
point. This amount is adjusted for inflation, anticipated changes in the workload of continuing
job, special job, and—if the data are readily available—the cost of comparable jobs in similar
units.
 Zero-Base Review
An alternative budgeting approach is to make a thorough analysis of each discretionary
expense center on a rolling schedule, so that all are reviewed at least once every five years or
so. Such an analysis is often called a zero-base review.
Cost Variability

 Unlike costs in engineered expense centers, which are strongly affected by short-run
volume changes, costs in discretionary expense centers are comparatively insulated from
such short term fluctuations.
 In preparing the budgets for discretionary expense centers, management tends to approve
changes that correspond to anticipated changes in sales volume—for example, allowing for
additional personnel when volume is expected to increase, and for layoffs or attrition when
volume is expected to decrease.
 Personnel and personnel-related costs are by far the largest expense items in most
discretionary expense centers.
Type of Financial Control

Financial control in a discretionary expense center is quite different from that in an engineered
expense center.
 Discretionary expense center
Financial control is primarily exercised at the planning stage before the costs are incurred.
The objective is to control costs by allowing the manager to participate in the planning,
sharing in the discussion of what tasks should be undertaken, and what level of effort is
appropriate for each.
 Engineered expense center
The objective is to become cost competitive by setting a standard and measuring actual
costs against this standard.
Measurement of Performance

 The primary job of a discretionary expense center’s manager is to obtain the desired
output.
 Spending an amount that is “on budget” to do this is considered satisfactory; spending
more than that is cause for concern; and spending less may indicate that the planned work
is not being done.
 In discretionary centers, as opposed to engineered expense centers, the financial
performance report is not a means of evaluating the efficiency of the manager.
 Total control over discretionary expense centers is achieved primarily through nonfinancial
performance measures.
A. Administrative and Support Centers

 Administrative centers include senior corporate management and business unit

management, along with the managers of supporting staff units.
 Support centers are units that provide services to other responsibility centers.
 Control Problems:
(1) The problems inherent in measuring output.
(2) The frequent lack of congruence between the goals of departmental staff and of the company as a
whole.
 The proposed budget for an administrative or support center usually consists of a list of
expense items, with the proposed budget being compared with the current year’s actual
expenses.
 Some companies request a more elaborate presentation, which may include a section
covering the basic costs of the center, the discretionary activities of the center, and
explaining all proposed increases in the budget.
B. Research and Development Centers

The control of research and development centers presents its own characteristic
difficulties:
 difficulty in relating results to inputs, and
 lack of goal congruence.
B. Research and Development Centers
The activities conducted by R&D organizations lie along a continuum, with basic research at
one extreme and product testing at the other.
 Basic research has two characteristics: (1) it is unplanned, with management at best
specifying the general area to be explored; and (2) there is often a significant time lapse
between the initiation of research and the introduction of a successful new product.
 In some companies, basic research is included as a lump sum in the research program and
its budget. In others, no specific allowance is made for basic research.
 For projects involving product testing, however, it is possible to estimate the time and
financial requirements—perhaps not as precisely as for production activities, but with
sufficient accuracy to permit a reasonably valid comparison of actual and budget amounts.
 In some cases failure is not discernible until after the product reaches the market.
R&D Program

 There is no scientific way of determining the optimum size of an R&D budget.

 Many companies simply use a percentage of average revenues as a base
 The specific percentage applied is determined in part by a comparison with competitors’
R&D expenditures and in part by the company’s own spending history.
 If a company has decided on a long-range R&D program and has implemented this
program with a system of project approval, the preparation of the annual R&D budget is a
fairly simple matter, involving mainly the “calendarization” of the expected expenses for
the budget period.
 At regular intervals, usually monthly or quarterly, most companies compare actual
expenses with budgeted expenses for all responsibility centers and ongoing projects.
C. Marketing Centers

There are two very different types of activities are grouped under the heading of
marketing, with different controls being appropriate for each.
 Logistics Activities - relates to the filling of orders. These are referred to as order
filling or logistics activities and, by definition, take place after an order has been
received.
 Marketing Activities - relates to efforts to obtain orders, and, obviously, take
place before an order has been received. These are the true marketing activities,
and are sometimes labeled as such; they may also be called order-getting
activities.
Case 4-6

Grand Jean Company

(page 181 - 184)

Question:
1. How would you describe the goal(s) of the company as a whole? Is this, or are these, the same
as the goal(s) of the company’s marketing organization and the company’s 25 managers of
manufacturing plants? Explain.
2. Evaluate the current management planning and control system for the manufacturing plants and
the marketing departments. What are the strengths and weaknesses?
3. Do you agree or disagree with the profit center concept for Grand Jean’s 25 manufacturing
plants? How would this approach affect the plant managers’ decisions, performance, etc.?
4. Evaluate these three alternatives. Which one would you recommend? Why is your selection the
best one?