©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter Nine

Responsibility Accounting

An accounting system thatprovides information . . .

Responsibility Accounting

Relating to theresponsibilities of

individual managers.

To evaluatemanagers on

controllable items.

Decision Making is Pushed Down

S u p erv iso r S u p erv iso r

M id d leM a na ge m e nt

S u p erv iso r S u p erv iso r

M id d leM a na ge m e nt

T opM a na ge m e nt

Decentralizationoften occurs asorganizations

continue to grow.

Decentralization

Decentralization

Improves qualityof decisions.

Encourages upper-level management toconcentrate on strategic decisions.

Improvesproductivity.

Developslower-levelmanagers.

Improvesperformanceevaluation.

Advantages

Successful implementation of responsibility accounting depends on clear lines of authority and clearly defined levels

of responsibility.

Successful implementation of responsibility accounting depends on clear lines of authority and clearly defined levels

of responsibility.

Vice Presidentof F inance

D epartm ent M anager

Store M anager

V ice Presidentof O perations

V ice Presidentof M arketing

President

B oard of D irectors

Organization Chart

Cost Center A business segment that

incurs expenses but does not

generate revenue.

Cost

Responsibility Centers

Profit Center A part of the

business that has control over both

revenues and expenses, but no

control over investment funds.

Responsibility Centers

RevenuesSalesInterestOther

CostsMfg. costsCommissionsSalariesOther

Investment Center A profit center

where management also

makes capital investment decisions. Corporate Headquarters

Responsibility Centers

Responsibility Reports

Prepare budgets for each responsibility center.

Prepare timely performance reportscomparing actual amounts with budgeted amounts.

Measure performance ofeach responsibility center.

Amount of detail varies according to level in organization.

Departmentmanager

receives detailed reports.

Store manager receives summarized information from each

department.

Management by Exception and Degree of Summarization

The vice president of operations receives summarized information

from each store.

Management by exception

Upper-level management does not receive operating

detail unless problems arise.

Amount of detail varies according to level in organization.

Management by Exception and Degree of Summarization

I’m in control

Controllability Concept

Managers shouldonly be evaluated on

revenues or coststhey control.

Since the exercise of control may be clouded,managers are usually held responsible for items

over which they have predominant ratherthan absolute control.

Since the exercise of control may be clouded,managers are usually held responsible for items

over which they have predominant ratherthan absolute control.

To be of maximum benefit, responsibility reports should . . .Be timely.Be issued regularly.Be understandable.Compare budgeted

and actual amountsof controllable items.

Qualitative Reporting Features

CostCenter

ProfitCenter

InvestmentCenter

Evaluation Measures

Profitability

Return on investment (ROI) Residual income (RI)

Cost controlQuantity and qualityof services

Managerial Performance Measurement

Return on investment is the ratio of income to the investment used

to generate the income.

ROI = Operating Income Operating Assets

Return on Investment

Return on Investment

A good example is interest you earn on your saving accountOperating Income = $50 interestOperating Assets = $5,000 ROI = $50 / $5,000 = 10%

ExampleGreen View is a lawn services

company whose operations are divided into two districts. The District 1 manager controls $12,600,000 of operating assets. District 1 produced $1,512,000 of operating income during the year. The District 2 manager controls $14,200,000 of operating assets. The District 2 reported $1,988,000 of operating income for the same period.

Example

What is the ROI for District 1?$1,512,000 / $12,600,000 = 12%

What is the ROI for District 2?$1,988,000 / $14,200,000 = 14%

Which District is performing better?

District 2

Another Example

Molly’s Pet Grooming has operating assets of $150,000. She

has a ROI of 22%.

How much is her operating incoming?

More Examples

Greg’s Greenhouse has an operating income of $144,000. The ROI is 18%.

What is Greg’s investment?

ROI = Operating IncomeOperating Assets

MarginMargin TurnoverTurnover

Return on Investment

ROI = ×Sales

Operating AssetsOperating Income

Sales

Rose Company reports the following:

Operating Income $ 40,000 Sales $ 400,000 Operating Assets $ 200,000

Let’s calculate ROI.

Return on Investment

ROI = 10% × 2 = 20%

Return on Investment

ROI = $40,000$400,000 ×

$400,000$200,000

ROI = ×Sales

Operating AssetsOperating Income

Sales

Improving R0I

Three ways to improve ROI

Increase Sales

Reduce Expenses

Reduce Operating Assets

Rose Company was able to increase sales to $500,000 which increased operating income to $45,000.

There was no change in operating assets.

Rose Company was able to increase sales to $500,000 which increased operating income to $45,000.

There was no change in operating assets.

Let’s calculate the new ROI.

Improving R0I

Rose Company increased ROI from 20% to 22.5%.

Improving R0I

ROI = 9% × 2.5 = 22.5%

ROI = $45,000$500,000 ×

$500,000$200,000

ROI = ×Sales

Operating AssetsOperating Income

Sales

ROI - A Major Drawback

As division manager at Rose Company,your compensation package includesa salary plus bonus based on your division’sROI -- the higher your ROI, the bigger your bonus.

The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%.

You have an opportunity to invest in a new project that will produce an ROI of 25%.

As division manager at Rose Company,your compensation package includesa salary plus bonus based on your division’sROI -- the higher your ROI, the bigger your bonus.

The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%.

You have an opportunity to invest in a new project that will produce an ROI of 25%.

As division manager would you invest in this project?

ROI - A Major Drawback

As division manager,I wouldn’t invest in

that project becauseit would lower my pay!

Gee . . .I thought we were

supposed to do what was best for the

company!

This condition is known as suboptimization.

How to Avoid Suboptimization

To avoid suboptimization, many businesses base managerial evaluation on residual income.This approach measures a manager’s ability to maximize earnings above some targeted level.The targeted level of earnings is based on a minimum desired ROI.

Residual Income

Operating Income– Investment charge = Residual income

Investment× Desired ROI = Investment charge

Investment center’scost of acquiring

investment capital

Residual Income

Residual Income = Operating Income – (Operating

Assets * Desired ROI)

Residual Income

Rose Company has an opportunity to invest $100,000 in a project that will earn $25,000.

Rose Company has a 20 percent desired ROI and a 30 percent ROI on existing business.

Rose Company has an opportunity to invest $100,000 in a project that will earn $25,000.

Rose Company has a 20 percent desired ROI and a 30 percent ROI on existing business.

Let’s calculate residual income.

Residual Income

Investment center’scost of acquiring

investment capital

Operating Income = $25,000– Investment charge = 20,000 = Residual income = $ 5,000

Investment = $100,000× Desired ROI = 20% = Investment charge = $ 20,000

Residual Income

As a manager at Rose Company, would you invest the $100,000 ifyou were evaluatedusing residual income?

Would your decision be different if you were evaluated using ROI?

As a manager at Rose Company, would you invest the $100,000 ifyou were evaluatedusing residual income?

Would your decision be different if you were evaluated using ROI?

Residual Income

Residual income encourages managers to make profitable investments that would

be rejected by managers using ROI.

Let’s apply what we’ve learned:

The Spokane Division of Cascade Inc. has a current ROI of 20%. The company target is 15%. The division has an opportunity to invest $4,000,000 at 18% but is reluctant to do so because its ROI will fall to 19.2%. The present investment base for the division is $6,000,000.

Should the company invest?

Responsibility Accounting and the Balanced Scorecard

The balance scorecard is a holistic

approach to evaluating managers.

The balance scorecard is a holistic

approach to evaluating managers.BalancedScorecard

Multiplefinancial

measures

Multiplenonfinancialmeasures

End of Chapter Nine