Performance assessment is crucial to management of any companies who wants to make sure that its operation is under control. To be able to go into deeper and more details assessment, they would need to view the company in segments—divided into several unit of operations, in the form of responsibility centers.
Using financial and non-financial control system, each center is assessed to get insight how’s each unit (responsibility center) of the company going, or why plans were not achieved—in a worst case, and make the appropriate adjustment. Based on the result of the assessment, they then are able to take necessary decision for their operation going forward (in short or long-run.)
Financial control summarizes the financial results of operation (in each responsibility center) and compares them to planned results. When companies (or organizations) use a single index to provide a broad assessment of operations, they frequently use a financial number, such as revenue, cost, profit, or return on investment. That is why each responsibility center is called “revenue/cost/profit/investment center”. By dividing the whole operation into business units—in the form of responsibility centers, executives are capable of controlling every facet of the business more effectively. They can even analyze and decide which business units deserve for expansion—or closed in the worst situation. In this post, I am going to discuss about responsibility centers and how to coordinate the center in a light overview. Read on…
What is Responsibility Center?
In short, a responsibility center is an organization unit for which a manager is held accountable. For example: accounting department in a company, a work station in a production line that makes computer units, a claims processing unit in an insurance company, a shipping department in a mail-order business, a hotel in a chain of hotels, or faculty in a university—in the case of not-for-profit organization.
A responsibility center is like a small business, and its manager is asked to run that small business to achieve the objectives of the larger organization. The manager and supervisor establish goals for the responsibility center. Goals provide employees with focus and should therefore be specific and measurable. They also should promote both the long-term interests of the larger organization and the coordination of each responsibility center’s activities with the efforts of all the others.
In a modern business environment that use “performance-based review,” benefits provided for the employee are linked into the performance of the responsibility center to which they are responsible for.
Responsibility Center Types
The accounting report prepared for a responsibility center should reflect the degree to which the responsibility center manager controls revenue, cost, profit, or return on investment. When preparing accounting summaries, you, as an accountant, want classify responsibility centers into one of the following four types:
1. Investment centers.
2. Profit centers.
3. Revenue centers.
4. Cost centers.
Next, let’s go deeper into each of the responsibility center.
1. Investment Centers
Investment centers are responsibility centers in which the managers and other employees control revenues, costs, and the level of investment. So an investment center, obviously, is like an independent business.
Not many companies or organizations have investment centers. Because to be treated as an investment center, a business unit should be significantly diverse to other units, senior management uses return on investment to evaluate each of these business units and their subunits.
General Electric is an example:
GE Infrastructure includes the sub-businesses of Energy, Technology Infrastructure, GE Capital, Home & Business Solutions, and NBC Universal. NBC Universal includes the subunit businesses of Network, Film, Television Stations, Entertainment Cable, Television Production, Sports/Olympic Games, and Theme Parks.
Those are truly diverse portfolios of businesses that must be evaluated in terms of the return on investment each provides.
2. Profit Centers
Profit centers are responsibility centers in which a team (a manager with supervisors and staff) controls both the revenues and the costs of the products or services they deliver. On the other side, the team also responsible for the result achieved.
A profit center is like an independent business, except that investment activities is controlled by senior management—not the responsibility center manager. For example, if the manager of one outlet in a chain of stores has responsibility for pricing, product selection, purchasing, and promotion but not for the level of investment in the store, the outlet meets the conditions to be evaluated as a profit center.
Most individual units of chain operations, whether they are stores, restaurants, or motels, are treated as profit centers. How about a unit of a corporate-owned fast-food restaurant or a corporate-owned hotel? Could they meet the conditions to be treated as a profit center when the head office makes most purchasing, operating, pricing, and promotional decisions?
Those units are sufficiently large, such that costs can vary because of differences in controlling labor costs, food waste, and the schedule for the facility’s hours. Revenues also can shift significantly, depending on how well staff manages the property. So the answer is YES they can be—for local discretion often affects revenues and costs enough.
Numerous organizations evaluate units as profit centers even though the corporate office controls many facets of their operations. The profit reported by these units is a broad index of performance that reflects both corporate and local decisions.
3. Revenue Centers
Revenue centers are responsibility centers whose members control revenues only—but do not control either costs, investment or profit aspects. Such revenue center for examples are: a regional sales office of a national or multinational corporation, a restaurant in a large chain of restaurants, or a book store in a general department store.
Some revenue centers control price, the mix of stock on hand, and promotional activities. In such centers, revenue will measure most of their value-added activities and will suggest in a broad way how well they carried out their various activities.
The revenue center approach evaluates the responsibility center based only on the revenues it generates. Most revenue centers incur sales and marketing costs, however, and have varying degrees of control over those costs. Therefore, it is common in such situations to deduct the responsibility center’s traceable costs, such as salaries, advertising costs, and selling costs, from its sales revenue to compute the center’s net revenue.
Consider the activities of an automobile service station owned by a large automobile company:
- The service center manager has no control over the cost of items such as fuel, depreciation on the building, power and heating, supplies, and salary rates.
- The service manager also has no control over the wages paid to employees—the head office staff controls them, and the central marketing staff controls all product pricing and promotional activities.
- The manager has a minor influence, through scheduling and staffing decisions, on total labor costs—level of the repair activities determine all other costs.
- The major controllable item in this service station is customer service, which distinguishes its repair services from those offered in similar outlets and helps to determine the service station’s sales levels.
4. Cost Centers
Cost centers are responsibility centers in which employees control costs but do not control revenues, profit or investment levels.
Every processing group in service operations (such as the cleaning plant in a dry-cleaning business, front-desk operations in a hotel, or the check-clearing department in a bank), virtually, is a candidate to be treated as a cost center.
Organizations evaluate the performance of cost center employees by comparing the center’s actual costs with budgeted cost levels for the amount and type of work done. Therefore, cost standards and variances figure prominently in cost center reports.
Moreover, because organizations often use standards and variances to assess performance, the process of setting standards and interpreting variances has profound behavioral effects on employees, particularly relating to misrepresenting performance potential and performance results.
When an organization unit’s mix of products and production levels is constant, it is possible to compare current cost levels with those in previous periods to promote an environment of continuous cost improvement.
Inter-period cost comparisons can be misleading when the production mix or the production level is changing. Under such conditions, cost levels between periods are not comparable; however, when circumstances warrant, organizations are often able to plot cost levels on a graph and look for downward cost trends, which imply improved efficiency in the processes that are creating costs.
Many organizations make the mistake of evaluating a cost center solely on its ability to control and reduce costs. Quality, response time, the ability to meet production schedules, employee motivation, employee safety, and respect for the organization’s ethical and environmental commitments are other critical measures organizations often use to assess cost center performance.
If management evaluates cost center performance only on the center’s ability to control costs, its members may ignore unmeasured attributes of performance such as quality and customer service. Therefore, organizations should never evaluate cost centers using only the center’s cost performance.
How To Coordinate Responsibility Centers
For an organization to be successful, the activities of its responsibility units must be coordinated. Unfortunately, in large organizations, sales, manufacturing, and customer service activities are often disjointed, resulting in diminished performance. This need for coordination explains the interest that organizations have in enterprise resource planning systems—that focus NOT ONLY on integrating the organization’s activities but ALSO on linking the organization with its suppliers and customers.
For easier understanding, consider that you’re a CEO of Lie Dharma Express (a mail and package courier services). The key formula for success in the courier business, are consisted of two elements:
(1) Meeting the service commitment to the customer: professionally, politely, on time, and without damage or loss, in picking the mail or package up from the shipper, AND delivering it to the recipients.
(2) Controlling costs
The only way for you to bring Lie Dharma Express into success is to ensure that all pieces of the system work together effectively and to achieve those two above critical elements of performance.
As you may very well know, a mail and courier services business such as Federal Express, establishes local stations or collection points (called terminals) from which they dispatch trucks to pick up and deliver shipments. Shipments that are bound for other terminals are sent to the Federal Express hub in Memphis (Tennessee), where they are sorted and redirected.
So you manage Lie Dharma Express in that way too. Next, suppose you and your management team decided that each terminal is to be treated as a responsibility center. How should you measure the performance of each terminal, its managers, and its employees?
1. You can measure efficiency in each terminal – To focus on efficiency, it may measure the number of parcels picked up, sorted, or delivered per route, per employee, per vehicle, per hour, or per shift. To focus on efficiency and customer satisfaction, it may count—for productivity purposes—only those shipments that meet customer requirements, for example, on-time pickup and on-time delivery of an undamaged parcel to the right address.
2. Lie Dharma Express’ ability to meet its service commitment to customers – In such a highly integrated operation as a courier business reflects how well the pieces fit together. The company should measure how much each group contributes to the organization’s ability to meet its commitments to customers. The following are the two important elements of terminal–hub interaction for a courier:
- The proportion of the time that the terminal meets its deadlines, that is, whether the trucks and containers are packed and ready to leave for the hub when they are required to leave (this is often called a percent correct measure).
- When terminals are required to sort shipments, the number of shipments sorted to the wrong destination or that travel by the wrong mode (often called a percent defect measure).
3. A more detailed level of services to customers – For example, it might measure the following:
- The number of complaints (or percentage of shipments with complaints) the terminal operations group receives.
- The average time taken by the operations group to respond to complaints.
- The number of complaints of poor or impolite service received by the company’s customer service line.
- Customer satisfaction.
In general, controlling the activities of responsibility centers requires measuring the non-financial elements of performance as well, such as quality and service that create financial results in the long run.
The key message is that: Properly chosen non-financial measures anticipate and explain financial results.
For example, increased employee training that improves operating performance in this period should improve customer satisfaction and therefore revenues and profits in subsequent periods.
Focusing on non-financial measures of performance such as innovation and employee morale motivates managers to avoid sacrificing long-run performance for short-run performance gains. For example, if you focus only on short-run financial performance, one or more of your manager might be motivated to reduce spending on research and development, investment in equipment to improve product quality and customer service, and employee training—thereby impairing long-run performance potential.
Therefore, you must always be careful to use financial results as aggregate measures of performance and rely on non-financial results to identify the causes or drivers of the financial results.