Responsibility Centers

About Me • Prof. Mahesh Halale B.Sc. M.B.A. M.C.A. • Worked with MSFC from 1985 to 2003 • Working with Vishwakarma Institute of Management since 2003 as an Assistant Professor (Approved by UoP) Written books on • Management Control Systems – Everest Pune • Management Information System – HPH Mumbai • Every year conduct a days workshop on Case Studies in MIS and MCS for all MBA students • Completed about 50 project finance consultancy tasks 10/17/08

[email protected]; VIM Pune

1

1

Agenda Topic – Responsibility Centers 3. Revenue Center 4. Cost Center 5. Profit Center 6. Investment Center

Concept Issues Performance Measures Examples Advantages and Disadvantages 10/17/08

[email protected]; VIM Pune

2

Responsibility Center Responsibility Center Responsibility center is an entity, held accountable for an activity/function under consideration, that becomes its objective/goal Organization can be looked upon as collection of responsibility centers. Each RC consumes certain amount of resources “INPUTS” and produces certain results “OUTPUT” Best option to assess the performance of RC starts with establishing relationship among INPUT and OUTPUT and then applying it scrupulously 10/17/08

[email protected]; VIM Pune

3

Responsibility Centers 1. Revenue Center Prime concern of the REVENUE CENTER – “TOPLINE” e.g. Marketing center Inputs Output RC’s (Money directly (Sales Generated TASK spent on achieving in money terms) sales i.e. Mktg. Exp.)

Generate Sales

• RC has no authority to decide price. • RC is charged with cost of Marketing and not with cost of goods produced • No formal relationship possible between I & O • Performance Measure for the RC can be Revenue Budgets. 10/17/08

[email protected]; VIM Pune

4

Revenue Center - Issues Decision Rights – Promotion Mix – Performance Measures – Maximize total sales for a given promotion budget Actual sales in comparison with budgeted sales Typically used when – RC manager has thorough knowledge about market Promotion plays significant role in generating sales RC manager can establish optimal promotion mix He can set optimal quantity and appropriate rewards 10/17/08

[email protected]; VIM Pune

5

2. Cost/Expenses Center: Engineered Expenses V/s Discretionary Expenses e.g. Manufacturing a product Can be established scientifically Cost varies with even small fluctuations in volume Control is easier. Control starts with planning & ends with finished task. Financial Performance measure suffice the purpose of evaluation.

10/17/08

e.g. R&D Project Can not be established scientifically Costs varies with bigger volume changes Review of task is the only control measure for cost control. Control is exercised during planning stage itself, by way of establishment of budget Financial as well as non financial Performance measure need to be 6 [email protected]; VIM Pune

Cost Center Inputs

RC’s TASK

(Money spent on production)

Output (Physical units Produced)

Decision Rights – Input Mix – Labor, Material, Supplies

Performance Measures – Minimize total cost for a fixed output Maximize output for a given “cost budget”

Typically used when – RC manager can measure output & quality of output knows cost functions, optimal input mix can set optimal quantity and appropriate rewards 10/17/08

[email protected]; VIM Pune

7

2. Expenses Center – 2.1)Engineered Exp. Center e.g. Production Department Engineered expenses are those expenses which are arrived at with reasonable reliability.e.g. Material cost , labor cost.

Inputs (Money spent on production)

RC’s TASK

Output (Physical units Produced)

• Performance Measure for the RC is std.cost: Std Cost of doing actual activity = Std. cost of unit activity * Quantum of Actual activity • One can establish relationship between I & O , hence performance measurement is relatively easy 10/17/08

[email protected]; VIM Pune

8

2. Expenses Center – 2.2) Discretionary Expenses Center -e.g. R&D, Advt. Dept, a Movie Project Discretionary expenses are those expenses which can not be established with perfect accuracy

Inputs (Money spent on R & D)

RC’s TASK

Output (Product Development)

• Difficult to estimate Input (hence called MANAGED costs) • Output can not be measured in monetary terms. • Difficult to establish optimal relationship between I and O • Performance Measure for the RC is Budgeted Input and Actual Input. 10/17/08

[email protected]; VIM Pune

9

Control Characteristics of Discretionary Cost Center • Heavy Reliance on Budgets • For on going activity its bit easier than a new project • Budgeting technique used for controlling could be – • Incremental Budgeting • Zero Base Budgeting • Difficult to control short term fluctuations, as Discretionary costs usually remain unaffected in short term unlike engineered costs.

10/17/08

[email protected]; VIM Pune

10

Discretionary Expenses Center - Examples i)

Administrative and Support Centers-

Senior management units at corporate level e.g. Legal, Planning , IT , Audit Departments •

Goals may differ and hence performance

ii) Research and Development Centers – •

The input and output may span over different and uneven time periods.

iii) Marketing Center -

10/17/08

[email protected]; VIM Pune

11

3. Profit Center Profit is most comprehensive measure of performance Function/Activity having highest influence on Bottom Line suits best for Profit Center. Can be a Business Division or any of the functional unit Demands highest freedom/autonomy than any other RCs’ Inputs (Money spent for earning profits)

RC’s TASK

Output (Money-profit Earned out of sales)

Relationship can be established

10/17/08

[email protected]; VIM Pune

12

Profit Center Decision Rights – Input Mix – Labor, Material, Supplies Product Mix Selling Price

Performance Measures – Actual Profits Actual Profit in comparison with budgeted profits

Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix CANDIDATES FOR PROFIT CENTER …………… 10/17/08

[email protected]; VIM Pune

13

3. Business Unit as Profit Center Business Units In a Decentralized Company Best suited as Profit Center Marketing Center as Profit Center– – Marketing Function having highest influence on Bottom Line, e.g. Colgate, Coca-Cola, Wipro- Bath Soaps division, Dabur-Cosmetics division etc.

– When centralized control is infeasible e.g. Foreign Marketing Center e.g. IBM, Microsoft, Honda India To Convert Marketing Division into Profit Center Charge cost of production to revenue center Grant of maximum autonomy to the unit Delegate sufficient authority Treat the unit as a mini company

10/17/08

[email protected]; VIM Pune

14

3. Functional Unit as Profit Center Manufacturing Division – – When Cost of production having highest impact on Bottom Line and – When Marketing Function is relatively insignificant e.g. Nirama Detergent

To convert a Production Division in to Profit Center Credit selling price less marketing expenses to production division

3. Service and Support Center – e.g. Maintenance, Customer Service, Transportation, Engineering Design Divisions

Given greater autonomy, helps them to cut cost and make its operations more efficient

10/17/08

[email protected]; VIM Pune

15

3. Profit Center – Performance Measures Justification

Performance Measure

• Revenue Less VC of Mfg. & Marketing

1. Contribution Margin

Fixed Cost is beyond control of PC

Less Fixed Expenses

2. Direct Profit

All Expenses incurred at the behest of PC

Less Controllable Corporate Expenses

3. Controllable Profit Less Other Corporate Allocations

4. Net Profit Before taxes Less Income tax

5. Net Profit

10/17/08

Some HQ expenses exclusively incurred for given PC at HQ – IT services Common unavoidable expenses incurred to run a company ; e.g. All administration, financing and tax planning activities are carried at HQ

In some cases RC do have impact on tax liability of the company Tax Heavens

[email protected]; VIM Pune

16

3. Profit Center - Advantages • Improves quality of decision – RC Mgr are closest to the point of decision • Improves speed of decision – less intervention by HQ • HQ is relieved of day-to-day decisions making process – can decisions

concentrate on more strategic

• Provides training ground for general mgt. as RC’s acts as mini Cos’. profit consciousness with every expense made. • Enhances promotional the sales).

(mktg. mgr. will tend to authorize expenditure which increases

• Provides best performance indicators of Co’s individual component. • Since output is clear cut evident, it evokes competition. • Ensures better and safer delegation of authority. • Ensures better motivation and evokes commitment.

10/17/08

[email protected]; VIM Pune

17

3. Profit Center – Dis-Advantages • Caliber of RC mgr. may hamper the decision. • Incase of more integrated company there may be problems of cost sharing, transfer pricing, sharing credit for revenue. • Divisionalisation may impose additional cost of admn/support units. • Functional set up may not have competent of GM to manage RC. • Functional units once cooperated may now be in competition with one another- (as profit of one is loss to another). • May encourage short term motive at the expense of Co’s overall goal. • Optimization of RC’s profit not necessarily mean optimization of company’s profits. • Decentralization makes top mgt. to rely more on MC reports 10/17/08

[email protected]; VIM Pune

18

Responsibility Centers 4. Investment Centers – Inputs (Money spent for Starting & running the business)

Output RC’s TASK

(Money/net profit Earned on account of investment)

• Objective – Make sound investment decision • It compares Business units profits with assets employed to earn that profit i.e. efficiency of assets employed. • It satisfies both the goals of business organizations i.e. to earn the profit and to achieve optimal relationship in profits earned and assets employed

10/17/08

[email protected]; VIM Pune

19

Investment Center Decision Rights – Input Mix – Labor, Material, Supplies Product Mix Selling Price Capital Investment

Performance Measures – Actual ROI Actual Residual Income i.e. EVA Actual ROI & RI in comparison with budgeted ROI & RI

Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix RC manager has knowledge about investment opportunities 10/17/08

[email protected]; VIM Pune

20

Return on Investment – Return on Investment Relating the profits of a firm with the investment made.  ROI can be computed in many different ways depending upon the need and relevance.

1. Return on Assets - ROA 2. Return on Capital Employed - ROCE 3. Return on Shareholder’s Equity - ROE 10/17/08

[email protected]; VIM Pune

21

Return on Investment – Return on Assets Net Profit 1) Return on Assets = --------------- * 100 Assets ROI terminology would change depending on what Assets base one takes for computation; it can be  Total Assets,  Fixed Assets,  Gross Assets,  Net Assets,  Tangible Assets or  Employed Assets 10/17/08

[email protected]; VIM Pune

22

Return on Investment – Return on Capital Employed Net Profit 2) Return on Capital Employed = ------------------------- * 100 Capital Employed  Capital implies the long term funds supplied by creditors &  Alternatively it can be owners Net Working Capital + Fixed Assets 10/17/08

[email protected]; VIM Pune

23

Return on Investment – Return on Shareholders’ Equity Net Profit 3) Return on Shareholders’ Equity = ---------------- * 100 Equity Capital Equity includes the preferential capital, however the ordinary shareholder bears the entire risk. Net Worth represents the equity capital plus the reserves and surpluses the portion solely represented by equity holders’.

Net Profit- Pref. Divi. Return on Shareholders’ Equity = ------------------- * 100 Net Worth 10/17/08

[email protected]; VIM Pune

24

Responsibility Centers 4. Investment Centers –

Economic Value Added - EVA® (Stern & Stewart) As lender require certain interest on their money, owners too expect certain rate of return on their funds. (taken together both termed as cost of capital). Hence no "real" money is made or value is created until the operating profits exceed the rupee return required by the owner and the lenders.

 Increase in EVA,  Increase in Market Value of the firm 10/17/08

[email protected]; VIM Pune

25

Economic Value Added –

EVA®

(Stern &

Stewart)

EVA is another of the way to relate profits to assets employed. • Economic Value Added = Net Profit – Capital Charge •

Capital Charge = Capital Employed * Cost of Capital • EVA=Net profit – (Cost of Capital * Capital Employed) • This is nothing but Residual Income which adds to the value of the firm

10/17/08

[email protected]; VIM Pune

26

Return on Investment V/s Economic Value Added 1. ROI is a ratio. Simple & easy to understand, Meaningful in absolute sense. Being a common denominator of industries it can used for comparison.

10/17/08

1. EVA is Profitability measure in money term. Can not be used for comparison with other Business Unit or Industries.

[email protected]; VIM Pune

27

Return on Investment V/s Economic Value Added 2. Different ROI % provides different incentives across BUs’ (e.g. BU having current ROI of 30 will be discouraged to go for additional investment giving 25% ROI, even though the ROI is greater than Cost of Capital OR

2. EVA provides an effective measure than ROI. EVA Stresses upon recovery of cost of capital. And welcomes every rupee earned over and above COC.

BU mgr can improve its ROI by just disposing the assets which give lesser 10/17/08 [email protected]; VIM Pune ROI than current one)

28

Return on Investment V/s Economic Value Added 3. ROI does not allow different treatment for different kind of assets i.e. it treats all assets/investments at par.

10/17/08

3. EVA enables to use different rates of interest for different types of assets involving different risks. e.g. low rate for inventory investment whereas higher rate for fixed investment.

[email protected]; VIM Pune

29

Return on Investment V/s Economic Value Added 4. It is difficult to define an explicit relationship between ROI and Market value of the firm. (ROI not necessarily indicate the market value of the firm.)

EVA has got strong & positive correlation with market value of the firm.

(shareholders worth maximization may not be suitable measure for RC’s performance evaluation Because it is consolidated effect of entire company) 10/17/08

[email protected]; VIM Pune

30

Computing EVA for HLL

Calculation of ROCE

1999

1998

1997

1996

Operation Profit

1,206

956

711

464

- Less Depreciation

129

101

58

55

- Less Tax Paid

318

286

281

173

5

8

11

17

562

361

219

2,118

1,703

1,412

688

19

18

19

22

402.42

306.54

268.28

151

351.58 255.46 [email protected]; VIM Pune

92.72

98 31

- Less Tax shield on interest Net Optg Profit less adj Taxes (NOPLAT) Average Capital Employed WACC (%) Capital Charge EVA 10/17/08

754

Thank You….

10/17/08

[email protected]; VIM Pune

32