6. Responsibility Centres and Divisions

Question 1

What is a controllable cost?

Answer 1

A controllable cost is a cost which can be controlled

Question 2

What is the manager of a cost centre responsible for, and how is performance assessed?

Answer 2

• Only costs incurred

- Cost variances and functional benchmarking

Question 3

What are the three categories of controllability used in a cost centre report?

Answer 3

1. Controllable and directly attributable
2. Attributable but not controllable
3. Non-attributable and non-controllable

Question 4

What is the manager of a revenue centre responsible for, and how is performance assessed?

Answer 4

• Sales/revenue generating activities

- Sales variances, revenue growth and market share

Question 5

What is the manager of a profit centre responsible for, and how is performance assessed?

Answer 5

• Both revenues and operating costs

- Variances for sales and costs, profit margins and growth

Question 6

What is the manager of an investment centre responsible for, and how is performance assessed?

Answer 6

• Revenues, operating costs and level of capital investment

- Measures for profit centres plus Return on Investment, Residual Income and Economic Value Added

Question 7

What is the equation for Return on Investment (ROI)?

Answer 7

Divisional Profit / Divisional Investment

Question 8

What is used for divisional profit in the ROI equation?

Answer 8

Profit before interest and tax, without head office allocations if looking at managers performance and with allocations if looking at the performance of the division

Question 9

What is used for divisional investment in the ROI equation?

Answer 9

TALCL or net assets

Question 10

What is a downside of using ROI?

Answer 10

It can lead to dysfunctional or non goal congruent behaviour of managers (make decisions in best interest)

Question 11

What is the equation for Residual Income (RI)?

Answer 11

Divisional profit - (Divisional investment x cost of capital)

Question 12

What is RI essentially comparing?

Answer 12

Profit actually made with minimum acceptable profit to the investors

Question 13

What are 4 reasons that ROI is often the preferred measure in organisations?

Answer 13

1. % answer easily understood
2. Interdivisional comparisons easier
3. Not felt that dysfunctional decision making happens often
4. RI needs an estimate of cost of capital

Question 14

How can we get around the issue of using historic/ NBV asset values in ROI/RI calculations?

Answer 14

Use replacement values

Question 15

Why is EVA considered to be a better measure to aid decision making?

Answer 15

It makes adjustment to both the profit and asset figure to better reflect the economic reality

Question 16

What is the equation for Economic Value Added (EVA)?

Answer 16

NOPAT (Net Operating Profit After Tax) - (WACC x adjusted opening net assets, based on replacement cost)

Question 17

What is the profit figure used in ERV?

Answer 17

NOPAT - start with operating profit and deduct the tax saving on interest, or start with PAT and add back interest net of tax

Question 18

How are training, R&D and advertising costs adjusted for in the EVA profit figure?

Answer 18

Added back to profit and amortised over their useful life

Question 19

How is depreciation adjusted for in the EVA figures?

Answer 19

Profit - add back accounting depreciation and deduct economic depreciation
Net assets - adjust for difference if not already at replacement cost

Question 20

How are provisions adjusted for in the EVA figures?

Answer 20

Remove movements in provisions from the NOPAT profit figure and add back brought forward provisions to opening net assets

Question 21

How are other non cash expenses adjusted for in the EVA figures?

Answer 21

Added back to profit and those from earlier years added back to opening net assets

Question 22

How are operating leases adjusted for in the EVA figures?

Answer 22

Capitalise their value to opening net assets and add back payments to profit

Question 23

What is the tax charge used in NOPAT?

Answer 23

The cash tax charge

Question 24

What are the 3 main benefits of using EVA?

Answer 24

1. Linked to cost of capital so tries to improve shareholder wealth
2. Closer reflection of cash flow
3. Reflects the economic reality

Question 25

What are the 4 main limitations of using EVA?

Answer 25

1. Short termist view
2. Adjustments are just as arbitrary as accounting ones
3. Involves many adjustments
4. Difficult to compare divisions of different sizes