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CHAPTER 4(PART 2): EXPENSE CENTRES

Expense centres are responsibility centres whose inputs, or expenses are

measured in monetary terms, but in which outputs are not measured in monetary
terms. Expense centres are of two types: (based on two types of costs)
1. Engineered costs/Standard costs: These are those for which the ‘right’ or
‘proper’ amount of costs can be estimated with a reasonable degree of
reliability. Costs incurred in a factory for direct labour, material, components,
supplies and utilities are examples. They have the following characteristics:
a. Their input can be measured in monetary terms.
b. Their output can be measured in physical terms.
c. The optimal rupee amount of input required to produce one unit of
output can be established.
In an engineered expense centre/standard centre, the output multiplied by the
standard cost of each unit produced represents what the finished product
‘should’ have costed. When this cost is compared to actual costs, the
difference between the two represents the efficiency of the organizational unit
being measured.
Example: Manufacturing operations that employ some form of standard
cost, warehousing, distribution and similar units within the marketing
organizations. Similarly, certain responsibility centres within
administrative and support departments for instance, accounts
receivable, accounts payable and payroll sections in the controller’s
department; personnel records and canteen in the human resources
department, shareholders’ records in the corporate secretary
department and company motor pool; perform repetitive tasks for
which standard costs can be developed. These engineered expense
centres are located within departments that are discretionary expense
centres.

It is necessary to note that apart from cost above, there are other important
tasks for engineered expenses centres to perform i.e., the type and level of
production are specified with specific quality standards, so that manufacturing
costs may not be minimized at the expense of quality. Further, managers of
engineered expense centres are responsible for activities such as: training
and employee development that are not related to current production; their
programme reviews include an appraisal on how well they carry out these
responsibilities.

It may also be noted, that there are few, if any, responsibility centres in which
all costs items are engineered. Process in highly automated production
departments, the use of indirect labour and various services can vary with
management’s discretion. Thus, the term engineered expense centre refers to
responsibility centres in which engineered costs predominate, but it does not
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imply that valued engineering estimates can be made for each and every cost
item.

2. Discretionary costs: (also called managed costs) are those for which no
such engineered estimate is feasible, the amount of costs depends on
management’s judgement about the amount that is appropriate under the
circumstances.

The word discretionary means that management has decided on certain

policies that should govern the operations of the company. For example,
manufacturer may grant an advertising allowance to a regional distributor of
10% per 1000 pieces of some products.
Example: Administration and support centres, R&D Centres and
marketing centres.

Management view about the proper level of discretionary cost is subject to

change. Dramatic changes may occur when a new management takes over.
There are three points in the control of discretionary expense centres:
a. the management control system helps only in expense control. The
budget for this type of expense centres represents the planned inputs to
the expense centre.
b. the difference between budgeted and actual expense is not a measure of
efficiency. It is simply the difference between the budgeted input and the
actual input.
c. the financial control system measures neither the efficiency nor the
effectiveness of these responsibility centres. It is necessary, therefore, that
non-financial measures and judgements be employed in evaluating their
performance.

3. Committed expenses: These are expenses that cannot be changed by the

responsibility centre manager during the budget year or expenses that can be
changed only in extraordinary circumstances. Depreciation is fixed by the
amount of depreciable assets in place during the year and can be changed
only by the disposal or addition of assets. Other examples are long-term
leases, salaries of key personnel. These amounts are not useful for
management control purposes; they are included in the budget to show the
overall profitability of business units and to indicate to responsibility centre
managers the size of the resources that they use. In judging actual
performance, the actual amount is set equal to the budgeted amount, so no
variance develops.

Approaches to budgeting with reference to engineered / standard and

discretionary costs: The starting point in preparing the budget is the current level
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of spending. The budgetee adjusts these amounts for anticipated inflation, cost
implications of the changes in the job to be done and in some cases for anticipated
productivity improvements. In some companies, the preparation of budget is
preceded by a zero base review.

In the case of engineered expense centre/standard cost centre, management must

decide whether the proposed operating budget represents the cost of performing a
task efficiently for the coming period. Once that is decided, based on the actions of
other responsibility centres such as: marketing department’s ability to generate
sales, magnitudes of the tasks is determined.

In the case of discretionary cost centre, while formulating the budget, managements’
principal task is to decide on the magnitude of the job that should be done, because
based on such job expenses/resources are budgeted. The following questions are
asked about a discretionary expense budget proposal:
1. What are the precise decisions that management should make?
2. Does the proposal include all the available information pertinent to making
these decisions?
3. Does the proposal include irrelevant information which, at best, will tend to
observe the real issues?
These tasks can be divided into two types: continuing and special. Continuing tasks
are those that continue from year to year, for example, financial statement
preparation by the controller’s office. Special tasks are one-time projects, for
example, developing and installing a profit budgeting system in a newly acquired
division.

Other Characteristics with Reference to Engineered/Standard Costs and

Discretionary Costs

1. Cost variability: In discretionary expense centres, cost tends to vary with

volumes from one year to the next, but they tend not to vary with short-term
fluctuations in volume within a given year. Whereas, costs in engineered
expense centres/standard centres are expected to vary with short-run
changes in volume. Hence, in preparing budgets for discretionary expenses
centres, managements tend to approve a change in their size that
corresponds to changes in budgeted sales volume i.e., additional personnel
are budgeted when volume is expected to increase, and lay-offs are planned
when volume is expected to decrease. Since personnel costs and personnel-
related costs are by far the largest expense item in most discretionary
expense centres; the annual budgets for these cost centres tend to be a
constant percentage of budgeted sales volume.
2. Type of financial control: Financial control exercised through an operating
expense budget in an engineered expense centre/standard centre attempts to
minimize operating costs by setting a standard and reporting actual costs
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against this standard. Costs are minimized by motivating line managers to

attain maximum efficiency and by giving higher management a means of
evaluating the efficiency of departmental management. The main purpose of
a discretionary expense budget, on the other hand, is to allow the superior to
control costs by participating in the planning. Costs are controlled primarily by
deciding what tasks should be undertaken and what level of effort is required.
Thus, in a discretionary expense centre, financial control is exercised at the
planning stage before the amounts are incurred.

Control Aspects of some Discretionary Expense Centres

1. Admin and support centres: These include senior corporate management
and business unit management along with the managers of the supporting
staff units. Support centers are units that provide services to other
responsibility centres. The control of admin and support centres is difficult
because of:
a. Problems inherent in measuring output: Some staff activities such
as payroll accounting are so routine that their units are in fact,
engineered expense centres. In other activities, the principal output is
advice and service - functions that are virtually impossible to quantify,
much less evaluate, since output cannot be measured, it is not
possible to set standards against which to measure financial
performance. Thus, a budget variance cannot be treated as either
efficient or inefficient performance.
b. Lack of goal congruence: Typically, managers of administration, staff
officers strive for functional excellence but to develop ideal system or
programmes or function will become too costly relative to the additional
profits that perfection may generate. The proposed budget for an
admin or support centre usually consists of list of expense items within
the current years’ actual expenses. Some companies have a more
elaborate presentation with the following components:
i. A section covering the basic costs of the centre including the
costs of being in business plus the costs of intrinsically
necessary activities for which no general management
decisions are required.
ii. A section covering the discretionary activities of the centre
including a description of the objectives and estimated costs of
each.
iii. A section fully explaining all proposed increases in the budget
other than those related to inflation.
2. Marketing Centres Two very different types of activities are grouped under
the heading of marketing - one relating to filling of orders, the other group of
activities relate to efforts to obtain orders and obviously take place before an
order is received. The first activity (also called logistic activities) are those
involved in moving goods from the company to its customers and collecting
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the amounts due from customers in return. These activities include

transportation to distribution centres, warehousing, shipping and delivery,
billing and related credit function and collection of accounts receivable. The
responsibility centres that perform these functions, some of them are
engineered expense centres that can be controlled through imposing
standard costs and adjusting budgets to reflect these costs at different levels
of volume. Marketing activities are those undertaken to obtain orders for
company products which include test marketing, the establishment, training
and supervision of the sales force, advertising and sales promotion. These
are basically discretionary expenses and depending on company’s policy the
expenses are budgeted. Further, though it is easy to measure a marketing
organization’s output, evaluating the effectiveness of the marketing effort is
much more difficult. This is because changes in factors beyond the marketing
departments control.
Example: Chronic Condition or the actions of competitors/may
invalidate the assumption on which the sales budgets are based. The
third activity is the generation of revenue which is, usually, evaluated
by comparing actual revenue and physical quantities sold with
budgeted revenue and budgeted units respectively.
3. Research and Development Centres
The control of research and development centers is difficult because of:
a. Difficulty in relating results to inputs. The results of R&D is difficult
to measure quantitatively but semi-tangible outputs in the form of
patents, new products or new processes but the relationship of output
to input is difficult to appraise on an annual basis because the
completed ‘product’ of an R&D group may involve several years of
effort.
b. Lack of goal congruence: e.g. the research manager typically wants
to build the best research organization money can buy even though
may be more expensive than the company can afford. Further,
research people do not have sufficient knowledge of (or interest in) the
business to determine the optimum direction of the research efforts.
The activities conducted by R&D centre lie along a continuum with
basic research at one extreme and product testing at the other. Basic
research has two characteristics:
i. it is unplanned with management at best specifying the basic
area to be explored and
ii. there is often significant time lapse between the initiation of
research and the introduction of a successful new product.
Since financial controls have little value in managing basic research
activities, alternative procedures are often employed. In some
companies, basic research is included as a lump sum in the research
programme and its budget. In some, the specific allowance is made for
basic research, but there is an understanding that scientists and
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engineers can devote the part of their line for basic research subject
only to the informal agreement of their supervisor.

For projects involving product testing, however, it is possible to

estimate the time and financial requirements - perhaps not as precisely
as possible but with sufficient accuracy to permit a reasonably valued
comparison of actual and budget amounts.

As the project moves along the continuum from basic research, to

applied research, to development, to production engineering, to testing
the amount spent per year tends to increase substantially.

R&D Programme: There is no scientific way of determining the

optimum size of an R&D Budget. Many companies use a percentage of
average revenues as a base. The specific percentage applied is
determined in part by comparing with competitors’ R&D expenditures
and in part by the company’s own spending history. Depending on the
circumstances, senior management may authorize a large amount in
budget if it appears that there has been a significant breakthrough.

The R&D programme consists of list of programmes plus a blanked

allowance for unplanned work; it is usually reviewed annually by senior
management. The review is often conducted by a research committee
consisting of CEO, the research director, and the production and
marketing manager. The committee makes broad decisions on the
projects to be undertaken, which to expand, which to cut back and
which to discontinue. The total amount of budget is allocated to
different projects, which is highly subjective.

For measurement of performance, the types of financial reports on R &

D are prepared. The first type compares the latest forecast of total cost
with the approved amount of each active project and circulated to
executives who control research spending. The second report
(financial) consists of comparison between budgeted expenses and
actual expenses in each responsibility centre. Neither type of reports
informs management the effectiveness of the research efforts.

Benchmarking and Cost Management: Benchmarking is the

continuous process of comparing and measuring an organization’s
business processes against those of business leaders anywhere in the
world. The objective is to identify and understand best practices; and
the best practice is simply, the best way to execute a process.
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We have seen that in engineered expense centre/standard cost centre,

finance control is exercised by setting a standard for performing the
task and reporting actual costs against this standard. While setting the
standard, we can get comparable standards from other operating units/
competitors in the process are called benchmarking.

Similarly, in discretionary expense centre, some of the logistic activities

e.g. transportation of the goods from the company to its customers,
billing and related credit function and collection of accounts receivable,
can be controlled through setting up standards and budgets that are
adjusted to reflect the costs at different levels of volume. While setting
up standards, benchmarking with other units/competitor unit is
possible.

The true power of benchmarking lies in the ability to apply the insight
gained from another organization’s best practices – with the full
understanding that it is adapting them or not adapting them. No single
best practice works anywhere. In fact, the term “best practices” is
something of a misnomer.

Case Study: Whiz Calculator

Bernard Riesman the new President of Whiz Calculator, background:
 had been with the company for 5 years
 VP of manufacturing division for 2 years.
The existing old method of planning & controlling selling cost was unsatisfactory.
 Whiz Calculator Company is into manufacturing the complete line of
electronic calculators. Their products are sold through branch offices to
wholesalers to retailers or directly to government or industrial users.
 Whiz Calculator Company is currently considering the new method of
planning and controlling selling cost.

Incremental Budgeting:
 Selling expenses were budgeted on a
“fixed” or “appropriation” basis.
 the accounting department sent
records of actual expenses for the
preceding year and for the current
year -to- date.
 Guided by this record, department
heads drew up & submitted estimates
of the expenses of their department
for the succeeding year.
 Final approval is in Budget
Committee
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Riesman believed, some weaknesses in old method.

1. Uncertainty the reasonableness of the estimates budget made by the
various department heads.
2. Selling condition often change after the budget was adopted.
3. But there is no guarantee if there are some increases in sales budget
expense then there would be an increase in sales volume.

Zero Based Review

 Old budgeted figures were divided into 12 equal amounts and compared
to each month actual results.
 Variable basis. Similar method that use in manufacturing. Setting selling
cost budget standards on a fixed and variable expense.
 Variable portion of the selling expense standard expressed as a certain
amount /per sales $.
 Set up a minimum sales volume which is 65% of current factory capacity.
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Disadvantage of using per sales $ as a variable

 That would not reflect important influences on cost as order size, selling
difficulty in certain territories, buyer psychology, etc
Advantages of using per sales $
 The most convenient measuring stick to use, the only figure readily
available from the records being kept.

The new method drastically reduce most of the unfavorable expenses in budget
report
Q1. From the information given in Exhibits 1, determine insofar as you can whether
each item of expense is
a. variable with sales volume
b. partly variable with sales volume
c. variable with some other factors or
d. not related to output volume at all.

Answer:
The old system, Exhibit 1, the figures of selling expenses are fixed or
appropriation based on the previous year and managers use it to estimate the
selling expense budget for succeeding year.
 However the result is that the selling expenses budgeting as an input are
not match with the expected output.
 So, the answer is (D). The old system, expenses are not related to output
volume at all.
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Q2. What bearing do your conclusions in question 1 have on the type of budgeting
system that is most appropriate?
Answer:
 After evaluate the old method and starting all from the scratch to find the
most suitable method for budgeting, The new method for budgeting is
most appropriate since attends to be more accurate in representing
between the flexible budget and the actual budget.
Q3. Should the proposed sales expense budgeting be adopted? Why or Why not?
Answer:
 It should be adopted.
 The new method, which is able to determine the flexible budget with
more accuracy and efficiently for predicting future demands for the
business and adjusting for unexpected external factors than can affect
productivity.
Q4. What other suggestions do you have regarding the sales expense reporting
system for Whiz Calculator?
Answer:
 Since the flexible costs are based on an amount per sales $ which it
doesn’t consider the nature of each selling territory , order size, or
consumer behavior.
 Plus, not all highlighted selling expenses are variable to sales and some
are only partly variable to sales.
 The company should learn to gather more data about market demands
for each region and do some research about consumer behavior analysis
or trend.