You’ve learned how segments are established within a business to increase decision-making and operational effectiveness and efficiency. In other words, segments allow management to establish a structure of operational accountability.
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The terminology changes slightly when we think about accountability relating to the financial performance of the segment. In a decentralized organization, the system of financial accountability for the various segments is administered through what is called responsibility accounting.
Responsibility accounting is a basic component of accounting systems for many companies as their performance measurement process becomes more complex. The process involves assigning the responsibility of accounting for particular segments of the company to a specific individual or group. These segments are often structured as responsibility centers in which designated supervisors or managers will have both the responsibility for the performance of the center and the authority to make decisions that affect the center.
Often, businesses will use the segment structure to establish the responsibility accounting framework. You might think of segments and responsibility centers as two sides of the same coin: segments establish the structure for operational accountability whereas responsibility centers establish the structure for financial accountability. Both segments and responsibility centers (which will likely be the same) attempt to accomplish the same goal: ensure all sectors of the business achieve the organization’s strategic goals.
Before learning about the five types of responsibility centers in detail, it is important to understand the essence of responsibility accounting and responsibility centers.
Fundamentals of Responsibility Accounting and Responsibility Centers
Recall the discussion of management control systems. These systems allow management to establish, implement, monitor, and adjust the activities of the organization toward attainment of strategic goals. Responsibility accounting and the responsibility centers framework focuses on monitoring and adjusting activities, based on financial performance. This framework allows management to gain valuable feedback relating to the financial performance of the organization and to identify any segment activity where adjustments are necessary.
Types of Responsibility Centers
Organizations must exercise care when establishing responsibility centers. In a responsibility accounting framework, decision-making authority is delegated to a specific manager or director of each segment. The manager or director will, in turn, be evaluated based on the financial performance of that segment or responsibility center. It is important, therefore, to establish a responsibility accounting framework that allows for an adequate and equitable evaluation of the financial performance of the responsibility center (and, by default, the manager of the responsibility center) as well as the attainment of the organization’s strategic goals.
This is not an easy task. There are several factors that organizations must consider when developing and using a responsibility accounting framework. Before discussing those factors, let’s explore the five types of responsibility centers: cost centers, discretionary cost centers, revenue centers, profit centers, and investment centers.
A cost center is an organizational segment in which a manager is held responsible only for costs. In these types of responsibility centers, there is a direct link between the costs incurred and the product or services produced. This link must be recognized by managers and properly structured within the responsibility accounting framework.
An example of a cost center is the custodial department of a department store called Apparel World. On one hand, since the custodial department is structured as a cost center, the goal of the custodial department manager is to keep costs as low as possible, since this is the basis by which the manager will be evaluated by upper-level management. On the other hand, the custodial department manager, who is responsible for cleaning the store entrances, also wants to keep the store as clean as possible for the store’s customers. If the store appears unclean and disorganized, customers will not continue to shop at the store. Therefore, the custodial department manager and upper-level management must work together to establish goals of the cost center (the custodial department, in this example) that satisfy the strategic goals of the business—maintaining a clean and organized store while minimizing the costs of managing the custodial department.
(Figure) shows an example of what the cost center report might look like for the Apparel World custodial department.
Just as with the cost center, let’s walk through an analysis of the December children’s clothing department profit center report. Overall, the department’s actual profit exceeded budgeted profit by $3,891, or 13.5%, compared to budgeted (or expected) profit. This increase was driven by a total revenue increase over budget by $29,200 or 19.8%. Recall from Building Blocks of Managerial Accounting that variable costs, unlike fixed costs, change in proportion to the level of activity in a business. Therefore, it should be no surprise that the expenses in the children’s clothing department also increased. In fact, the expenses increased $25,309 (or 21.4%) versus the budgeted amount. The revenues of the department increased $29,200, while expenses increased $25,309, yielding an increase in profit of $3,891 over expectations.
The increase in revenue could be further analyzed. Because the store also sells accessories such as belts and socks, the children’s clothing department tracks two revenue sources (also called streams)—clothing and accessories. Management was pleased to learn that clothing revenue exceeded expectations by $30,000, or 20.7%. Given the higher-than-usual level of snowfall in the area, this is an impressive increase, and the company can attribute a portion of the successful month to the employees of the custodial department, who worked extra hard to ensure customers could easily and safely enter the store.
The overall revenue of the department increased by $29,200. Since the clothing department revenue increased by $30,000, the clothing accessories revenue stream must have experienced a decline in revenue. In fact, the accessories revenue dropped by 36.4%. While this is a large percentage, consider the fact that the actual value of revenue decline was relatively minor—only $800 lower (as indicated by the negative amount) than expected. This indicates the employees may not have encouraged customers to also get belts or socks with their clothing purchase. This is an opportunity for the department manager to remind employees to encourage customers to purchase accessories to complement the clothing purchases. Overall, the increase in revenue attained by the children’s clothing department is a highlight for the store.
A review of the department’s expenses shows increases in all expenses, except department manager wages and cost of accessories sold. When reviewing the profit center report, pay special attention to how the differences between the actual and budgeted expenses are calculated in this analysis. In the revenue section, a positive number indicates the revenue exceeded the budgeted amount, which means a favorable financial performance. In the expense section, a positive number indicates the expense exceeded the budgeted amount, which means an unfavorable financial performance.
As with the custodial department manager, the manager of the children’s clothing department is also a salaried employee, so the wages do not change each month—the wages are a fixed cost for the department. Since the clothing accessories revenue declined, the cost of accessories also declined. The accessories expenses were $576 lower than expected. While this appears to be good news for the department, recall that clothing accessories revenue dropped by $800. Therefore, the department profit margin decreased by a net amount of $224 versus expectations ($800 revenue decline and a corresponding expense decrease of $576).
All other actual expenses were over budget, as indicated by the positive numbers. Remember, these are expenses, and in this analysis, they indicate unfavorable financial performance. It probably comes as no surprise that all of the expense overages are a result of the increased sales. Because of the increased sales, more associates were needed to cover each shift, and they worked more hours to cover the longer store hours, which caused wages to go over budget. The substantial increase in clothing revenue also caused the cost of clothing sold to increase proportionately. Similarly, the increased sales drove an increase in equipment/fixture repairs of $735 (or 253.4%) over budget due to repairs to cash registers and clothing racks. Because the store was open longer hours during the holiday season, the utilities expenses also exceeded budget by $275, or 44.4%.
Overall, the Apparel World department store management was pleased with the December financial performance of the children’s clothing department. The department exceeded budgeted sales, which resulted in an increase in department profitability. The review also highlighted an area for improvement in the department—increasing accessory sales—which is easily corrected through additional training.
Notice that the review of the children’s clothing department profit center report discussed differences measured in both dollars and percentages. When analyzing financial information, looking only at dollar values can be misleading. Displaying information as percentages—percentage of an entire amount or percentage change—standardizes the information and facilitates an easier and more accurate comparison, especially when dealing with segments (or companies) with vastly different sizes.
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Let’s look at another scenario using Apparel World. The example so far has explored the financial performance review processes for a cost center and a profit center. Now assume that store management wants to compare two different profit centers—children’s clothing and women’s clothing. (Figure) shows the December financial information for the children’s clothing department, and (Figure) shows the financial information for the women’s clothing department.