Extensive summary covering chapter 4 - 11 from the book Management Controls Systems (Second Edition).
The book is used for the course Advanced Management Accounting at Erasmus University Rotterdam (EUR, Erasmus School of Economics), as part of the Major Financial Accounting.
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Samenvatting Management Control Systems, 2e - Management Control (EBB102B05)
Summary Accounting & Contol (management control systems)
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Economie En Bedrijfseconomie
Advanced Management Accounting
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ADVANCED MANAGEMENT ACCOUNTING PART 2
CHAPTER 4 RESPONSIBILITY CENTERS
Responsibility centers:
An organizational unit that is headed by a manager who is responsible for its activities
A responsibility center exists to accomplish one or more objectives. A company has a
mission, goals and strategies. If every RC reaches meets it objectives, then the company
should as well.
A responsibility center receives inputs, their objective is to transform/processes these with
capital and creates output, either tangible or intangible (goods or services).
Managing RC’s bring a lot of challenges.
Efficiency: The ratio of outputs to inputs, or the amount of output per unit of input.
Effectiveness: Relationship between a RC’s output and its objectives.
Efficiency vs effectiveness can have a negative trade-off
By making more cost a company can be more effective (e.g. achieve more goals), but less
effective (e.g. more cost per unit produced).
5 different types of RC’s
- Engineered expense center Optimal relationship can be established
- Discretionary expense center No optimal relationship
- Revenue center Inputs not related to outputs
- Profit center Inputs related to outputs
- Investments center Inputs related to outputs
What type of RC is appropriate for an organizational unit?
Choice of type is based on four things:
1. The core operations of a unit and the measurement possibilities of input and output.
2. The organizational structure.
3. The controllability principle (important for motivational purposes): the manager should
only be assigned responsibility for the revenues, expenses/costs and/or assets that are
within their control. It is very demotivating for managers to be held accountable on
things they cannot influence.
4. Specific strategic concerns (Apple will not easily limit R&D spending, Hilton Hotels
commits to superior service and doesn’t want to decrease spending on good personnel,
Volvo with a completely new unit for electric cars (Polestar).
Engineered expense centers (manufacturing unit)
Euro’s input, Physical outputs. Optimum can be determined.
- Inputs can be estimated with reasonable reliability: direct labor, materials, components,
utilities etc.
- Their input can be measured in monetary terms.
- Their output can be measured in physical terms.
- The optimum monetary amount of input required to produce one unit of output can be
determined.
, o Compare standard versus actual costs. We know this as the variance analyses
- Since only costs are important to the manager, a manager may:
o Skimp on quality control, shipping product of inferior quality in order to obtain
standard cost credit Set specific quality standards.
o Be reluctant to interrupt production schedules in order to produce a rush order
to accommodate a customer Set production scheduling.
o Lack the incentive to manufacture products that are difficult to produce – or to
improve the standards themselves.
- Turning an expense center into a profit center may resolve all the problems. If properly
designed, it doesn’t matter if products are sold within the company or to outside
companies.
Discretionary Expense Centers (Administrative and support units, R&D operations and
marketing activities)
Euros input, physical output. R&D function. There is no strong relationship between costs
and output.
- (Managed expenses): Expenses for which no such engineerd estimate feasible and is
depent on management’s judgement.
o E.g. match the marketing efforts of competitors; level of service provided to
customers; appropriate amounts of spending for R&D.
o R&D can take several years to complete a ‘product’.
o The levels of discretionary expenses may change over time.
Managers strive for functional excellence
- May goal congruence as ideal system too costly.
- May lead to empire building.
Control of a discretionary expense center depends on the effective establishment of a
reference point to which the actual expenses can be compared
- E.g. gain superior’s approval before budget is overrun; spending less than budget does
not indicate efficiency.
- Control through non-financial performance such as quality .
Revenue centers (usually sales units; Adidas example in book, not clear when increased
input results in an increased revenue of a unit)
- Output is measured in monetary terms. No formal attempt to link input and output.
A manager of a revenue center is evaluated by measuring sales or bookings made
against budgets or quota.
- It is a simple and effective way to motivate salespeople to attract and retain
customers.
- Little incentive to look at costs and assets deployed (invested capital).
- Salespeople should know there are not just working for their own unit.
- Besides measuring financial metrics for evaluations, non-financial performance can
also be evaluated (e.g. Customer relationships, check on quality of
products/services).
,Profit centers (e.g. Lufthansa, wanted different operations to be more entrepreneurial, to
make profits for the company)
- Business unit is responsible for generating profit (revenues – expenses/costs).
- Profit measures both efficiency and effectiveness.
Investment Centers
Same as profit centers, but also consider the amount of assets deployed to obtain the profit.
- Investments centers’ performance can be compared to other investment units, or
similar outside companies.
- Manager should be motivated to achieve the following objectives:
o To generate adequate profit from assets and;
o To only invest in additional assets/resources if they generate adequate
profit/return for the unit.
Conditions that should be met before delegating profit and assets employed responsibilities:
1. Managers should have access to relevant information needed for decision making.
2. There should be a way to measure the effectiveness of the trade-offs the manager
has made.
Advantages of profit/investment centers
- Improved quality of decisions by lower managers (lower-level managers are closer to
the actual operations and have better oversight).
- Lower-level manager can make faster decisions, they don’t have go through to
hierarchy of a company and thus, decisions are often more effective.
- Top management can focus on strategic issues.
- Excellent training ground for lower-level managers to become a general manager.
- Increasing profit consciousness for lower-level managers (what is profit and how can
my business unit generate it?)
Disadvantages of profit/investment centers
- Loss of control by higher management.
- Increased control costs (need to create and maintain MC Systems).
- Quality of decisions can be lowered if lower-level managers do not have sufficient
knowledge or don’t comply to the company’s goals/strategy.
- Friction and arguing on transfer prices between business units.
- Business units may start to compete with each other, leading to dysfunctional
decision making.
- It may be hard to find competent business unit managers.
- Business unit managers may focus too much on short-term profits or return on
investments. They should focus also on the middle- and long term.
Constraints on profit and investment centers
- To realize benefits the profit centers must have a certain amount of autonomy: the
manager needs to be autonomous president of an independent company.
- Organizations divided into completely independent units lose the advantages of size
and synergy.
, - Top manager must still be responsible for the company and cannot withdraw their
own responsibility.
- Top manager gives away some of their responsibilities and power, they must have
the feeling that this is compensated by the additional performance of the business
units itself (trade-offs between unit autonomy and corporate constraints).
ADVANCED MANAGEMENT ACCOUNTING PART 2
CHAPTER 5 TRANSFER PRICING
What is transfer pricing? A satisfactory method of accounting for the transfer of goods and
services from one responsibility center to another in companies that have a significant
number of these transactions. It is a mechanism to distribute revenue/profit if two or more
RC’s are responsible for e.g. product development, manufacturing or marketing.
- It should provide each responsibility center with the relevant information it needs to
determine the optimum trade-off between company costs and revenues.
- It should induce goal-congruent decisions (the system should be designed so that
decisions that improve RC’s profits will also improve company profits.
- It should help measure the financial performance of the individual RC’s.
- The system should be simple to understand and easy to administer.
- It should be acceptable to the tax authorities if the two RCs are located in different
tax jurisdictions.
TRANSFER PRICING METHODS
The fundamental principle of transfer pricing
Transfer prices should be similar to the prices that would be charged if the product were
sold to outside customers or purchased from outside vendors (market). When profit or
investments centers of a company buy products from, and sell to, one another, two
decisions must be made periodically for each product:
1. Should the company produce the product inside the company or purchase it
from an outside vendor? This is the sourcing decision.
2. If produced inside, at what price should the product be transferred between
profit/investment centers? This is the transfer price decision.
Marketing price-based is the ideal situation and will induce goal congruence (goals of RC
align with company goals) only possible if the following conditions are met:
- Competent people: manager should be interested in long-run as well as short-run
performances of their RCs Staff involved in negotiations should also be competent.
- Good atmosphere: manager must regard profitability as an important goal and a
significant consideration in the judgement of their performance, transfer prices should
be just.
- A market price: the ideal transfer price is based on a well-established, normal market
price reflecting the same conditions (quantity, delivery time and quality) as the product
to which the transfer price applies. The price may be adjusted downwards to reflect
savings due to dealing inside the company (no advertising or selling costs).
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