Department of Economics and Business Management Rosa M.

Batista Canino
ULPGC Arturo Melián González

LESSON 4
RESPONSIBILITY CENTRES

4.1. Responsibility Centre: concept ........................................................................................................ 1

4.2. Engineered Expense Centres ........................................................................................................... 3
4.3. Discretionary Expense Centres ........................................................................................................ 4
4.4. Revenue Centres .............................................................................................................................. 4
4.5. Profit Centres ................................................................................................................................... 5
4.6. Investment Centres .......................................................................................................................... 6
4.7. Criteria for assessment of responsibility centres .........................................................................12
4.7.1. The controllability criterion.......................................................................................................12
4.7.2. Goal congruence criterion .........................................................................................................13

4.1. Responsibility Centre: concept

Responsibility centres (RCs) are organizational units under the management of one person, who is
assigned a series of objectives. These centres are of vital importance to the Management Control System,
since performance evaluation is undertaken based on the objectives allocated to each center. Thus, they
constitute the cornerstone of the Management Control System.

In this way, a company can be seen as a collection of responsibility centres that form a hierarchy, where
those of the higher levels integrate or are made up of other of lower level. For example, a hotel chain can
comprise several hotels, where each one can be a RC. At the same time, each individual hotel can comprise
several departments, that will be other RCs if they meet the requirements defined above.

All responsibility centres have to meet some objectives, and also get some results. The former can be
defined as desired outcomes, and the latter as what they actually achieve. They are also similar in that
they use inputs to obtain outputs. However, they differ in the type of activity which they engage in and
the difficulty which they face when measuring the relationships between these inputs and outputs. These
differences have to be taken into account when comparing the actual results with those which were
forecast or expected. So, for example, two responsibility centres that could exist in a factory producing
chairs are the assembly unit and the design unit.
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

Some examples

• Centre 1: The Chair Assembly Unit

Inputs: wood, screws, labour, etc.

Output: chairs

Activity: the assembly of wood and other materials.

• Centre 2: The Design Unit

Inputs: Knowledge, ideas, experience, etc.

Outputs: Concrete products

Activity: designing.

Both centres can be visualized in the same way:

Inputs Process Outputs

That is to say, both units receive some inputs and after some kind of process produce outputs. These
inputs and outputs, however, cannot be measured in the same way, and therein lies the difference
between them. It is possible to know the quantity of material used to manufacture a particular chair. On
the other hand, this cause/effect relationship is not so easy to calibrate when it comes to establishing the
amount of resources necessary to come up with a determined number of successful designs.

Responsibility centres can be classified in the following ways, based on the kind of activities which they
carry out:

a. Engineered expense centres

b. Discretionary expense centres
c. Revenue centres
d. Profit centres
e. Investment centres

Efficiency and effectiveness

To set objectives to RCs and to assess to which extent those objectives have been met, two criteria are
generally used: efficiency and effectiveness. In short, efficiency can be seen as the ratio of outputs to
inputs, or the amount of output per unit of input. We would say that RC A is more efficient than RC B if it
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

consumes fewer resources than RC B but produces the same output, or if it uses the same amount of
resources but produces a greater output.

On the other hand, effectiveness is determined by the relationship between a RC output and its objectives.
So the more this output contributes to the objectives, the more effective the RC is (Anthony and
Govindarajan, 2007). Those objectives are the ones that have to do with the output of the RC, so in many
cases they are linked to the level of activity of the unit or the desired attributes of its output (e.g., quality
of the company’s products).

4.2. Engineered Expense Centres

Engineered expense cost centres are those centres whose activities give rise to costs, or in other words,
the activities they undertake basically mean spending money, and they are not responsible for any
revenue. Furthermore, in these centres the relationship between inputs and outputs can be estimated or
calculated with a reasonable degree of accuracy, so the cost of either outputs or the results of any activity
can be clearly established. An understanding of this relationship comes from the experience and
knowledge the centre has about the output; for example, in the case of making bread, it will be the baker,
with his experience, who decides what amount of input – yeast, flour, water etc. – is necessary in order
to obtain the output (bread) of a quality and size he or she considers appropriate.

The most typical example of an engineered expense centre is a Production Department. Once the
standard or ideal cost of the inputs to achieve the desired outputs has been set, it will be taken as the
target cost to aim for. A comparative analysis of budgeted and actual costs should be made without
considering the difference between the quantity of goods expected to be produced and those actually
produced. This way of proceeding would be based on the assumption that the volume of production
depends on sales, which is not the responsibility of this kind of centre. Thus, the variance between the
standard and the actual cost per product unit can be favourable for the company when they spend less
than expected, or unfavourable when their costs are higher than predicted. (Obviously without lowering
the quality of the product, since if this occurs the costs and standards are not comparable).

Also, as we have seen in lesson 3, the variance for the cost per product unit is determined when we are
dealing with variable costs; when costs are fixed, the assessment would be based on the difference
between the budgeted and actual total fixed costs.

It is necessary to be aware that the variances mentioned above evaluate the efficiency of the centre -the
quantity of resources used per unit of output – and not its effectiveness. That is, aspects like the quality
of the output or the fulfilling of certain requirements in its production should be evaluated using other
indicators distinct from cost per unit. For example, in the example of a Production Department, some
measure about the quality of the products should also be used to evaluate this RC.
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

4.3. Discretionary Expense Centres

Unlike in the case of engineered expense centres, it is not possible to observe a precise relationship
between inputs and outputs in discretionary expense centres. An example of this type of expense centre,
in any company, is the R+D department. It is very difficult for this department to establish the quantity of
resources that need to be invested in order to create new products with success. A company can spend a
great deal of money on R+D and obtain poor results while another that only spends a little can be lucky
or be more effective and develop a product that is profitable for the company. Other costs of this type
are those of advertising, creating a sales network and others connected with commercial activities.
Generally speaking, commercial costs that arise before the sale of a product or a service are usually of this
nature. For costs of this type, management have to decide on a fixed amount of resources, based on their
experience, expectations and knowledge, in other words, on a subjective judgement. Obviously, their
evaluation should not be limited to comparing their budget with the actual cost, as this variance will not
be related to the efficiency of the centre. Other indicators that have to do with effectiveness should be
used, for example, the number of designs made successfully, or the savings made by innovations to the
company’s processes. Clearly, the indicator used will depend on the nature of the objectives the centre
has to evaluate.

4.4. Revenue Centres

Revenue centres are the areas of the business whose activities basically give rise to some revenue. The
most usual example is the Marketing Department. When the centre of responsibility is engaged in selling,
there is an easily measurable output: sales figures. Nevertheless, it is not revenue that businesses
generally aim to maximize but profits. This must be taken into account when the terms used to formulate
the objective of a sales department are being defined.

Example:

The company MM estimates that if it sells its product for 5 euros per item it will manage to sell 1,000
units, whereas it will sell 1,750 items if the price is fixed at 3 euros. The variable cost per product unit is 2
euros.

Alternative A: Price 5 euros

Revenue: 1,000 units x 5 = 5,000 euros

Margin per product unit: 5-2 = 3 euros

Total contribution margin: 1,000 x 3 = 3,000 euros

Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

Alternative B: Price 3 euros

Revenue: 1,750 units x 3 = 5,250 euros

Margin per product unit: 3-2 = 1 euro

Total contribution margin: 1,750 x 1 = 1,750 euros

As can be understood, dropping the price may lead to more revenue, but this increase could not
compensate for the lower margin and, thus, the fall in profits.

To avoid the above situation occurring, when setting their objective a centre of revenue should include
not only the revenue – the price and quantity sold – but also the cost of the products, thereby introducing
the notion of margin. When the time comes to evaluate the objective, it is necessary to compare the
revenue actually obtained with the costs of achieving it. This can be done in the following way:

Budgeted total contribution margin (objective) → 𝑝 𝑏 ∗ 𝑞𝑏 − 𝑣𝑐 𝑏 ∗ 𝑞𝑏

Actual total contribution margin → 𝒑𝒂 ∗ 𝒒𝒂 − 𝒗𝒄𝒃 ∗ 𝒒𝒂

Where,

p= price q = quantity vc = variable cost

a = actual b = budget

In both the budgeted and the actual margins the budgeted cost is used, so the difference between the
two will be due to any change in the quantity of sales and the sales price, variables which usually are the
responsibility of the sales department.

4.5. Profit Centres

Profit centres are those units of the company that generate not just revenue itself, but also the
expenditure necessary to obtain or produce those revenue, and the person responsible for this part of
the company makes decisions concerning both. Divisions in corporations usually overlap with profit
centres, since they manage both revenues and expenditures. It is important to note that the evaluation
of expense and revenue centres does not intend to measure profitability, but whether certain objectives
have been achieved. This is because these centres only control either costs or revenue. In contrast, it is
possible to determine profitability in profit centres because they have control over costs and revenue as
well. Regarding all this, their objective is generally set in terms of making a profit.

These centres have a more global objective, one which is more similar to that of the whole company which
they are part of. This means that they can delegate more decision-making and, in addition, be more
autonomous. Thus, for example, if the person in charge decided to lower costs by reducing the quality of
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

the product, this would affect revenue and, therefore, profits. In a cost centre, taking the same decision
would not have such a direct impact on meeting objectives, because sales do not form part of its objective.
This is why expense centres cannot enjoy so much autonomy as profit centres.

4.6. Investment Centres

An investment centre is one in which the person responsible for the centre makes decisions not only about
aspects related to revenue and expense but also about the investment made by the centre, whether it be
in fixed assets or in working capital. In other words, an investment centre is a profit centre in which the
manager in charge can determine what investment is made. In such centres, it is necessary to evaluate
the profits accrued from any investment. There are several indicators which can be used to measure
profit, the most commonly used being the ratio of return on investment (ROI) and the economic value
added (EVA).
𝐸𝐵𝐼𝑇
𝑅𝑂𝐼 =
𝐼𝑛𝑣
𝐸𝑉𝐴 = 𝐸𝐵𝐼𝑇 − 𝑘 ∗ 𝐼𝑛𝑣

Where:

EBIT = Earnings before interest and taxes,

Inv = investment, and

k = cost of capital

The advantages of using ROI to establish objectives and control activities in these centres are as follows:

a. It allows for the standardization of results in that it is possible to compare the results of distinct
units or divisions, independent of the amount of investment made. This is so because of what the
ROI actually is: the ratio between EBIT and investment.

Example

EBIT = 1.500.000 euros

Division A ROI = 0,15

Investment = 10.000.000 euros

Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

EBIT = 300.000 euros

Division B ROI = 0,3

Investment = 1.000.000 euros

Taking into account the amount of investment made by each unit, unit B can be said to have produced
the best results because its ROI is higher.

b. ROI can be compared with the cost of capital. Accordingly, if the ROI is higher than the cost of
capital (k), the investment is worthwhile for the company. Since both indicators are ratios this
comparison is feasible.

ROI > k = it is worth the investment

c. The ROI can be useful for people outside the company since they can compare it with that of other
companies or businesses or with their cost of capital. The ROI can also be easily calculated by
financial analysts.

On the other hand, it is necessary to bear in mind certain points connected to the use of the ROI and EVA.

a. The value of the ROI or EVA can differ depending on whether an evaluation is being made of
the performance of the unit as a business or whether the aim is to evaluate the management of
the person responsible for the unit.
The manager of an investment centre may only decide about part of the investment and the rest
of it may be decided on by the head office. If the aim is to evaluate the management of a centre,
it, therefore, seems logical that such an evaluation should only include what the management
has control over.
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

Example

Income statement

 Revenue 3.500

 Variable costs -1.600

Contribution margin 1.900

 Controllable Fixed costs -300

Controllable earnings before interest 1.600

 Interest (controllable funding) 150

Controllable income 1.450

 Non controllable expenses: 1.150

- Fixed costs 800

- Interest 350
Income 300

Balance sheet
5.000 Non-current assets (non-controllable) Equity 19.000
18.000 Non-current assets (controllable) Non-current liabilities 4.000
(3.000) Depreciation Current liabilities 1.500
2.200 Inventory
1.900 Accounts receivable
400 Cash
24.500 24.500

Assessment of the manager:

Controllable earnings (EBIT) = 1.600

Controllable investment (controllable non-current assets + working capital) = 18.000

Assessment of the RC:

EBIT = Controllable earnings before interest - non controllable fixed costs = 1.600 – 800 = 800
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

Investment = Controllable non-current assets + non-controllable non-current assets + working capital =

23.000

ROI = 800/23.000 = 0,0348

b. Valuation of non-current assets

Investment –denominator of the ROI and part of the subtrahend of EVA– consists of non-current
assets and working capital. While EBIT –the numerator of the ROI and the minuend of EVA– and
working capital are determined on a yearly basis according to the fiscal year, non-current assets
are valued at the acquisition price of previous years if the historical acquisition cost is used to
that end. So, depending on which criterion is used to value the investment, the ROI and the EVA
can have different values.
Three criteria which can be used to value an investment are:
- Gross book value
- Net book value (without any depreciation deduction)
- Replacement value

We will see below how the use of one rather than another will alter, for example, the value of the ROI.

- Value of the non-current assets calculated at gross book value (purchase or acquisition
price):

𝐸𝐵𝐼𝑇 ∗ (1 + 𝑖)𝑡
𝑅𝑂𝐼 =
𝐶 ∗ (1 + 𝑖)𝑡 + 𝐼

In this case, the value of the ROI tends to rise with the passage of time since part of the
denominator – the investment – is not affected by inflation.

- Value of the non-current assets calculated at net book value (purchase or acquisition price
minus accrued depreciation (AA)).

𝐸𝐵𝐼𝑇 ∗ (1 + 𝑖)𝑡
𝑅𝑂𝐼 =
𝐶 ∗ (1 + 𝑖)𝑡 + 𝐼 − 𝐴𝐴

In this case, the problem explained above is worsened because the value of the asset
gradually falls over time as it depreciates more and more.
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

- Value of the non-current assets calculated at replacement value.

𝐸𝐵𝐼𝑇 ∗ (1 + 𝑖)𝑡
𝑅𝑂𝐼 =
𝐶 ∗ (1 + 𝑖)𝑡 + 𝐼 ∗ (1 + 𝑖)𝑡

where t = time that has elapsed since EBIT and investment was calculated; i = inflation rate; AA = Accrued
depreciation since t; C = working capital.

c) In turn, as far as the ROI is concerned, if a centre of responsibility uses this indicator as a measure to
set objectives and evaluate their achievement, before any new investment is decided upon, the goal
cannot simply be that any new projects will increase the ROI of the unit. If this were the principle that the
manager responsible for any new investment had to adhere to, it could give rise to a situation where they
undertake projects with a ROI below the cost of capital of the company – the minimum rate of return that
a business requires on a new investment. This situation is possible when the ROI of the unit is below the
capital cost of the company. Under these circumstances, the ROI of the unit can increase if it takes on a
project which has a return on investment higher than that of the division, even though the ROI of the new
investment is less than the cost of capital of the company. The same thing does not arise with EVA,
because its calculation incorporates the cost of capital, which is why whatever new project with a yield
below the cost of capital of the company would make the value of EVA worse for the division, it would be
rejected. The following example will illustrate this situation.

Example

Company “X” is made up of two units which have the following investment projects:

Division A Division B

Initial
600 1.100
investment

ROI 17% 19%

Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

The current situation and that which would be produced with the investments described above are:

Division A Division B Company

Current situation
 Investment 1.500 2.800 4.300
 ROI 15% 20% 18,3%

Current situation +
Investment Project Division
A
2.100 __ 4.900
 Investment
15,6% __ 18,1%
 ROI
Current situation +
Investment Project Division
B
__ 3.900 5.400
 Investment
__ 19,7% 18,4%
 ROI

If unit A went ahead with the project, it would increase its own ROI but that of the company would
decrease. On the other hand, if unit B accepted the project, its own ROI would fall but that of the company
as a whole would rise. This problem disappears if, instead of using the ROI, EVA is used as an indicator. So
projects that will generate a profitability superior to the cost of capital should be selected or, in other
words, those where the investment is expected to increase EVA.

Division A Division B
Current situation
 Investment 1.500 2.800
 EBIT 225 (1.500*0,15) 560 (2.800*0,2)
Cost of capital (18%) 270 (1.500*0,18) 504(2.800*0,18)
EVA (45) (225-270) 56 (560-504)
Potential situation
Investment 2.100 (1.500+600) 3.900 (2.800+1.100)
EBIT 327(225+600*0,17) 769(560+1.100*0,19)
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

Cost of capital (18%) 378 (2.100*0,18) 702 (3.900*0,18)

EVA (51) (327-378) 67 (769-702)

As shown in the table above, if EVA were used for the evaluation of investment centres, the management
of unit A would not accept the project but that of unit B would do so. Both decisions would benefit the
company, since they would be consistent with the overall goals of the business. In this sense, the use of
EVA can avoid goal incongruence between those of the units and the global objectives of the company.

4.7. Criteria for assessment of responsibility centres

How to establish objectives in responsibility centres and evaluate their achievement is a significant
question. To answer it, the following criteria or principles must be taken into consideration:

- Controllability
- Goal congruence

4.7.1. The controllability criterion

When evaluating a centre of responsibility, it would seem logical to only take into account the activities
which are the responsibility of that centre and no others. For example, if a revenue centre is being
evaluated, the revenue generated should be considered but not the production costs incurred, since those
are not the responsibility of such a centre.

The problem which arises, if such a strict principle is adhered to, is that it assumes that the manager of a
centre alone can control their own actions. However, the results of a RC are to a greater or lesser extent
influenced by external factors beyond their control. The application of this criterion means that for a
company it is the results of a centre that are of interest, rather than the decisions which have been taken
to achieve them. In addition, on many occasions, it is not easy to tell how much of the outcome is due to
the correct decision having been taken and how much is due to luck.

In order to apply the criterion of controllability rigourously and to only consider that which is in fact the
product of the actions of the manager of the centre, it would be necessary to evaluate each one of the
decisions he or she took. Thus, the contribution of the manager to the achievement of the objectives of
the company could be measured. As seems obvious, this would not work, since more time could be spent
evaluating the decisions than actually making them directly in the first place, so the delegation of decision-
making would be senseless.

For this reason, in practice what happens is that a control of the results of the centre is made based on a
number of indicators such as revenue, expenditure and profits, amongst others. The performance of these
indicators will be influenced by variables, some of which the manager of the RC will have control over but
others of which they will have no control over. For instance, engineered expense centres are not
responsible for sales volume. For this reason, this variable should not be part of the indicator that will be
used to assess their performance. the objective can be isolated and formed in such a way that this
uncontrollable variable has no bearing on it. In any case, the behaviour of other uncontrollable variables,
Department of Economics and Business Management Rosa M. Batista Canino
ULPGC Arturo Melián González

such as the low morale of employees at a certain period of time, or humidity would be more difficult to
isolate and, thus, their influence on the results of a centre hard to determine.

4.7.2. Goal congruence criterion

A Management Control System consists of a system which measures factors that are relevant for the
success of the company, and usually an incentive system linked to the results of this measurement. There
are different types of incentive: they can concern money or status, but whatever type of incentive is
offered they must promote goal congruence.

For goal congruence to exist means that if the manager responsible for the centre makes a decision in
order to achieve or exceed the objective that has been set (with a view to ensuring that the evaluation of
their centre will be the best), this, in turn, should have a positive impact on the profits and general
objectives of the company. In other words, the objectives of their centre of responsibility and those of the
company as a whole must follow the same path. Therefore, goal congruence exists when each centre,
while trying to achieve its own objectives, contributes clearly to the fulfilment of those of the company as
a whole.

In practice, goal congruence is not easy to bring about. This is because it is not so simple to break down
the general objectives of the company into objectives for each centre. For example, if a cost centre is
given the objective of minimizing costs, it could achieve this by reducing the quality of the product. This
decision would, however, be likely to have negative repercussions for the company. Alternatively, a
revenue centre could be required to maximize revenue, but to achieve this, the person in charge could
choose to reduce prices, which could have a negative impact on company profits.

In both cases, the general objectives of the company would be to increase profits, but the partial
objectives would not be congruent with this, because those in charge of the particular responsibility
centres would, in the pursuit of fulfilling their own centre´s objective, harm the company as a whole. Thus,
it is necessary to try to establish partial objectives, for each centre of responsibility, which are congruent
with the overall company objectives.

The more global the objective of a centre is, the easier it is to obtain goal congruence. For example, it
would be simpler to set a congruent objective to a profit centre than to a cost centre. The former could
be asked to increase its profits, which would usually benefit the company as a whole. If the latter,
however, were just asked to reduce costs, it might, in doing so, harm the company itself. In turn, the more
independent a centre is, the easier it is to achieve goal congruence. Thus, if there are two completely
independent units, who both try to maximize profits, this would have a positive impact on the company.
However, if they were not independent, what one unit does will affect the other and a decision that could
have positive consequences for one could have negative results for the other.
THE CONTENTS OF THIS LESSON ARE BASED ON:

Anthony, R. N. and V. Govindarajan (2007). Management Control Systems. McGraw Hill.

Ballarín Fredes, E, Rosanas Marti, J. y Grandes Garcia, M.J. (1999). Sistemas de planificación y control.
Desclée de Brouwer.

Mallo, C. y Merlo, J. (1996). Control de gestión y control presupuestario. McGraw-Hill.