Lecture 2: Responsibility Centers

Question 1

What is the basic control problem linked to responsibility centers?

Answer 1

Goal congruence.

Different activities are performed by different people. Activities are grouped into units, decision-making is decentralised to the managers of these units, and they are assigned financial responsibilities.

Question 2

What is the assignment of responsibility to different organizational units important for?

Answer 2

To ensure the effectiveness of the management control system in large organizations. Requires acceptance of responsibility for performance

Question 3

What is a responsibility center?

Answer 3

Organizational units headed by managers responsible for the unit’s activities and performance. Financial responsibility is assigned to them.

→ important skeleton of a management control system.

Question 4

What is centralisation?

Answer 4

• Most of the decision-making authority is reserved for top management.
• Control is exercised through central planning and monitoring of deviations from these plans.

Question 5

What is decentralisation?

Answer 5

• Delegation of decision-making authority to lower levels of the organization.
• Provision of sufficient material and formal resources to execute that authority.
• Assignment of accountability and responsibility for the quality of decision-making.

Question 6

What are some advantages of decentralisation?

Answer 6

• Greater responsiveness to local needs
• Quicker decision-making
• Increases motivation
• Aids management development and learning

Question 7

What are the main types of responsibility centers?

Answer 7

• Investment center
• Profit center
• Revenue center
• Expense center (standard cost/engineered and discretionary)

Question 8

What are the four criteria for assigning financial responsibilities?

Answer 8

1. The core operations of the unit or subunits (based on the organizational structure).
   - The activities performed in a unit is the starting point
   - Difference between functional units and business units
2. The measurement possibilities of input and output.
   - You can’t manage what you can’t measure
3. The controllability principle.
   - Managers should be responsible only for the revenues, expenses and/or assets employed they can influence. Important for motivational purposes.
4. Strategic concerns.

Question 9

What are the three general organizational structures?

Answer 9

• Functional organization. Each manager is responsible for a specified function such as production or marketing.
• Business unit organization. Managers are responsible for most of the activities of their particular unit, and the business unit functions as a semi-independent part of the organization.
• Matrix organization. Functional units have dual responsibilities, to both a functional manager and a business unit manager. A mix of functional and business unit structure.

Question 10

What is the rationale of a functional organizational structure?

Answer 10

• Manager brings specialized knowledge related to a specific function
• Better decisions in respective field. Can supervise employees better.
• Takes advantage of economies of scale: all similar tasks are conducted in one department or unit → efficiency.
• Competence development from learning from each other within the unit.

Question 11

What are some disadvantages of a functional organizational structure?

Answer 11

• Unambiguous determination of the effectiveness of separate functional managers.
• Disputes between functions can only be resolved at the top level.
• Tend to prevent cross-functional coordination in areas such as new product development (lack of integration).

Question 12

What are some advantages of a business unit organizational structure?

Answer 12

• Provides a training ground in general management
• Sounder production and marketing decisions than HQ since closer to the market.
• Increased understanding of other functions than your own core competence.

Question 13

What are some disadvantages of a business unit organizational structure?

Answer 13

• Each business unit’s staff may duplicate some work that would be done at HQ in a functional organization.
• BU managers are typically generalists, but must manage problems addressed by specialists both above and below them.
• Less likely to learn from each other (R&D) - suffering functional competence development.

Question 14

Who do you report to in a matrix organizational structure?

Answer 14

Each operational manager has two managers. The functional manager is responsible for increasing integration between the units of that function, while the BU manager is responsible for increasing integration within the BU. Cooperation between these managers rather than competition is important for success.

Question 15

What is efficiency?

Answer 15

The relation between input and output (output/input). Amount of output per unit of input.

Doing things right!

Question 16

What is effectiveness?

Answer 16

The relation between a unit’s output and its objectives. The more output contributes to the objectives, the more effective the unit is.

Doing the right things!

Question 17

What is the main rule of the controllability principle?

Answer 17

Managers should be assigned responsibility only for the revenues, expenses and/or investments that are within their control

Question 18

What can happen if managers are held responsible for factors that they cannot influence?

Answer 18

• At best, lack of motivation.
• At worst, dysfunctional and/or fraudulent behavior.

Question 19

What are the components of the basic model for analysing allocation of responsibility to managers?

Answer 19

Based on the core operation of the responsibility center:

1. Input
   - Resources used by the responsibility center.
   - Can we measure it in physical terms or monetary terms?
2. Output
   - The results of the activities performed in the responsibility center (goods or services).
   - Can we measure it in physical terms or monetary terms?
3. Causality
   - The relation between input and output. Sometimes difficult to determine.

Question 20

What are the key features of an investment center?

Answer 20

• Both input and output are measured in monetary terms.
• Input and output are closely linked (causality).
• Capital is used when generating output.
• Manager is responsible for trade offs → much freedom (like CEO of a standalone company) → evaluate with profit-capital measures (return on investment): both IS and BS

Question 21

When are investment centers appropriate?

Answer 21

When managers can influence profit and the assets employed in earning it.

Question 22

What are the key features of profit centers?

Answer 22

• Both input and output are measures in monetary terms.
• Input and output are closely linked (causality).
• Manager is responsible for revenues and expenses, i.e. profit. Makes trade-offs among price, volume, quality and costs.

Question 23

When are profit centers appropriate?

Answer 23

When the manager can influence both revenues and the matching expenses, but not the investment base.

Question 24

What are some advantages of profit centers (& investment centers)?

Answer 24

1. Decision-making quality.
   - Higher information relevance
   - Greater responsiveness to competitive challenges
2. Management capacity.
   - Frees up senior management through delegation
   - Training ground for general management
3. Business sense.
   - Profit consciousness
   - Instead of doing things to promote sales, a sales manager responsible for profit will be motivated to make promotion expenditures to increase profit.

Question 25

What are some disadvantages of profit centers (& investment centers)?

Answer 25

1. Lower quality of decision-making at unit level
   - Lack of competent staff
2. Coordination costs
   - Risk of intra-firm competition
   - The profit of one unit could be the loss of another unit (especially if functional units and internal transfer pricing)
3. Risk of goal incongruence
   - Short-term profitability overemphasized
   - Sub-optimization: optimization of individual parts not automatically equal to the company’s best interest

Question 26

How is profit related to efficiency and effectiveness?

Answer 26

It is a comprehensive indicator of both combined

Question 27

What are the key features of revenue centers?

Answer 27

• Output is measured in monetary terms.
• Lack of influence over input (only direct expenses).
• Manager is responsible for setting prices to influence revenues (& volume + mix of sales).
• Evaluation: actual sales vs budgets
• No attempt to relate input to output

Question 28

When are revenue centers appropriate?

Answer 28

When managers can influence output, and output can be measured in monetary terms, but they cannot influence the cost of the products and services they sell

Question 29

Why are revenue centers linked to a risk of goal incongruence and how can it be handled?

Answer 29

• May promote low-profit products since they are not aware of the cost of goods sold
• May extend credit terms to customers for a higher price (increase revenue, reduce ROI)

Could be managed by:
- Complementary measures of effectiveness (e.g. customer satisfaction rates)
- Rules of conduct
- Transforming the unit to a profit center through internal transfer pricing

Question 30

What are the key features of engineered expense centers?

Answer 30

• Input is measured in monetary terms.
• Outputs can be estimated with reasonable reliability because of the standard link between inputs and outputs.
• Standardized activities: physical output = volume * standard cost
• Can hence specify the amount of inputs required to produce each unit of output.
• Responsibility: the relation between input and output, how resources are used, cost efficiency/productivity.
• Evaluation: difference between the theoretical cost and the actual cost.

Question 31

Why is there a risk of goal incongruence in engineered expense centers and how can it be handled?

Answer 31

To reach efficiency:
- Is employee training and development reduced?
- Minimizing manufacturing costs at the expense of quality?
- Is the production schedule followed? (other units depend on the production level)

→ Need to complement efficiency targets with quality and timeliness measures (effectiveness).

Question 32

What are the key features of discretionary expense centers?

Answer 32

• Input is measured in monetary terms.
• It is difficult to measure physical output (not standardised).
• It is difficult to relate input to output.
• The optimum level of spending is a matter of management’s judgment. Focus on desired level and quality of output.
• Set budget for accepted level of inputs for the job to be done. Not good to spend less if it means output is not obtained.
• Functional excellence not necessarily better than good enough if it is costly for the company as a whole

Question 33

When are discretionary expense centers appropriate?

Answer 33

When units produce outputs that are not readily measurable and/or where no strong relationship exists between inputs and outputs.

Question 34

What are two basic needs of organizations, and how do these relate to management control systems?

Answer 34

• Differentiation: need for special competence in different areas
• Integration: need for people with different competencies to cooperate towards some kind of common goal or purpose.

The higher the differentiation, the harder it is to achieve integration. The way the management control system is designed in organizations means that it often tends to favor differentiation because of its mainly vertical character.