Management Control Systems Chapter 7: Financial Responsibility Centers (and the Transfer Pricing Problem) Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003

Financial results controls ... Three core elements: Financial responsibility centers The apportioning of accountability for financial results within the organization. Formal management processes (planning & budgeting) To define performance expectations and standards for evaluating performance. Motivational contracts To define the links between results and various organizational incentives.

Definition ... Responsibility center ... Organization unit that is headed by a responsible manager; It denotes the apportioning of responsibility for a particular set of inputs and/or outputs to an organization unit. Responsibilities can be expressed in terms of ... Physical units of outputs; Particular characteristics of the services provided; e.g., schedule attainment, customer satisfaction, etc. Quantities of inputs consumed; Financial indicators of sets of performance in these areas. Financial responsibility centers ... Responsibility centers in which the manager's responsibilities are defined at least partially in financial terms.

Revenue centers ... Managers of revenue centers are held accountable for generating revenues, which is a financial measure of outputs. e.g., Sales departments in commercial organizations; e.g., 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: These costs are only a tiny fraction of the revenues generated; Revenue centers are not charged for the costs of the goods they sell.

Expense centers ... Managers of expense (cost) centers are held accountable for expenses, which are a financial measure of the inputs consumed by the responsibility center. Two types: Standard cost centers or engineered expense centers Inputs can be measured in monetary terms; Outputs can be measured in physical terms; and, Causal relationship between inputs-outputs is direct / stable; e.g., manufacturing departments, but also, warehousing, distribution, personnel administration, catering. Managed cost centers or discretionary expense centers Outputs produced are difficult to measure; and, Relationship between inputs-outputs is not well known; e.g., R&D, PR, HR, marketing activities.

Control in expense centers ... Engineered expense centers Standard cost vs. actual cost i.e., 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; training; etc. Discretionary expense centers Ensuring that managers adhere to the budgeted level of expenditures while successfully accomplishing the tasks of their center. Subjective, non-financial controls e.g., quality of service as perceived / evaluated by users. Personnel controls Tools: benchmarking

Profit centers ... Managers of profit centers are held accountable for generating profits, which is a financial measure of the difference between revenues and costs. As a measure of performance, profit is ... Comprehensive i.e., it incorporates many aspects of performance; Unobtrusive i.e., the profit center manager makes the revenue/cost tradeoffs. Main question / problem in practice: 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.

Measuring profitability ... Revenue Cost of goods sold Gross margin Advertising + promotion Research + development Profit before tax Income tax Profit after tax Gross Margin Center Incomplete Profit Before-tax Complete 

Investment centers ... Managers of investment centers are held accountable for the accounting returns (profits) on the investment made to generate those returns. Measures: ROI, ROE, ROCE, RONA, etc. 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.

Typical organization structure ... Administrative and Financial Vice Presidents (D /ECC) President (IC) Group Vice President SBU Manager (PC) Procurement (ECC) Manufacturing Sales (RC) Divisional Staff Functions (D/ECC) ...