Management control

TOPIC 2 : DRIVING PERFORMANCE WITH RESPONSIBILITY CENTERS

1. Principles of performance measurement systems in a decentralized
organization
2. Different types of responsibility centers
3. Introduction to transfer prices
4. Link to the individual performance evaluation of managers

Decentralization

▶ Decentralization : grants substantial decision making authority to the

managers of subunits
▶ Typically, decentralization is a matter of delegation
- Decentralization has advantage when responsibility accounting works well
- It requires multiple parties to make their own independent decisions

Source : Professor Hyun, Neoma, 2018

 Decentralization requires a
performance measurement system
To monitor delegation to sub-units, management uses objectives to
which resources are allocated
= The Management by Objectives principle (MBO)

Sub-units are accountable of the use of their delegation through the reporting of
their results, linked to objectives

Responsibility Delegation of
accounting decision
making and
resource
allocation

Management
control
Performance measurement in a
decentralized organization
Sub-business units can have their own performance
measurement systems, which improves the benefits
of decentralization => "auto-control"

Management control
Management control in a decentralized
organization
Management control benefits both to the hierarchy and
to the business units

Hierarchial control
Central management
control
Business units
control
Local
management
control
Management control in a decentralized
organization
Responsibility

• The expected results from sub-units must be clearly defined =>

they must be translated into a performance measurement
system
– Group performance must be extended to local performance
– The local performance measurement system must be consistent
with how much authority is delegated to the sub-unit
• A monetary incentive system (variable compensation system)
is often associated with the performance measurement system
Decentralization and responsibility
centres
A responsibility center is:
1. A company sub-unit
2. To which some authority has been delegated i.e. the ability to decide on
management and resource allocation (human, financial, material…)
3. In order to reach an identified financial objective

 5 types of responsibility centers

 The type of RC translates the financial responsibility of the sub-unit

 The RC type is defined according to the potential financial outcomes of
the decisions and actions of the sub-unit
Types of responsibility centers

Profit
Profit Revenue
Revenue
Discretionary
Discretionary Center
Center Center
Center
cost
cost center
center
Investment
Investment
Center
Center
Standard
Standard
cost Responsibility
Responsibility
cost center
center
Centers
Centers
 1. Standard cost center (CCS)
Mission: to produce the right quantity, with the right quality, at
the right cost.

 Manages costs (not revenues)

 Delivers services that can be counted
 Type of performance measured = efficiency

Use of a flexible budget

Budgeted variable unit cost x actual volume + total unit
costs

Example: a production unit

 2. Discretionary cost center
Mission: ensure the best possible service without exceeding
the allocated budget

 Manages costs (not revenues)

 Delivers services that cannot be counted
 A lot of functional services are DCC
• R&D, Accounting department, RH department…
• maintenance, ordering/launching, engineering office

Financial indicators are not relevant:

How can their performance be measured?
 3. Revenue center
Mission: maximize sales by optimizing sales force
management

 Manages sales volume (and sometimes costs)

 No authority on the "4P's" of the marketing-mix (not
even on price)
 Costs are mostly variable (linked to the sales volume)
 Performance measures:
• Revenues with prices defined somewhere else
• + potentially % commercial costs/revenues

Example : simple sales department

 4. Profit center
Mission: profit maximization

 Sells all or a part of their products/services internally or

externally
 Can act on some elements of the marketing-mix
 Can choose between different action plans that can act on profit/volume/cost
Profit = volume x (price – variable unit cost) - fixed costs
 Manages selling price and/or costs that are not only
variable and that may influence the sales volume
 Performance measure = Profit level
Examples : regional office, business unit, commercial function that
can act on some elements of the marketing-mix
 5. Investment center
Mission: maximize return on investment

 Same latitude as a profit center plus…

freedom to invest in assets or use assets
NB: stocks and receivables are assets….

 Performance measures
o ROCE = EBIT/ Capital Employed
or
o EBIT – cost of capital...
Example: operational unit, subsidiary, in general, any company
 Summary (1/2)
Nature of responsibility Goals
centre
Standard cost centre optimize costs, producing the right quantities with the
right quality;
Revenue centre Develop turnover without any action on the marketing-
mix
Discretionary cost centre Give the best possible service while respecting the cost
envelope
Profit centre Optimize profit. delegation on at least two elements of
cost/volume/price
Investment centre Optimize return on capital employed
 To be completed

Summary (2/2)
Delegated financial flows
Type Income statement B.S.
Costs Turnover Assets
X
Cost Center
(X depends on
Revenue center turnover) X
X X
Profit center
Investment center X X X
RC traditional hierarchy
INVESTMENT CENTER

PROFIT CENTER

STANDARD COST DISCRETIONARY

CENTER COST CENTER REVENUE COST CENTER
The organization of responsibility
centers
• A cost center or a revenue center cannot
manage a profit or an investment center

• A revenue or a cost center cannot manage an

investment or a profit center

• Performance must be assessed on every

controlled dimension

 Possibility to use transfer prices

 Transfer price

Production transfer Sales

Direct production Transfered Direct commercial Turnover 90
costs 50 income 55 costs 20
Transfer cost 55
Contribution = + 5 Contribution = +15

Company A
Direct commercial Turnover 90
costs 20
Direct production
costs 50
Company A = sales + production

Income = + 20 = 5+15
Your turn…

• Internal supplier direct costs: 70 K€

• Internal client direct costs: 30 K€
• External turnover of internal client: 115 K€
• Transfer price: 80 K€

Fill the next slide without the transfer price

mechanism and with the transfer price
mechanism
 To be completed

Transfer price, 2nd example

Internal supplier Transfer Internal client

Direct costs 70 Transfered Direct costs 30 Turnover 115
income 80
Transfer cost. 80
Contribution = 10 Contribution = 5

Company A
Internal client direct Turnover 115
cost 30
Internal supplier cost
70
Company A : internal supplier + internal
client
Income = 15 = 10 + 5
 What are transfer prices used for ?
 To give managers a sense of responsibility :
with transfer prices, managers behave so that
they serve the interests of the group
 The congruence principle : managers must
not favor their own RC at the detriment of the
group
 Fair evaluation of CR through the use of
contributions

Tax optimization : mostly for international

groups. not studied in this class
Some remarks…
1. All responsibility centres can use
transfer prices

2. A cost centre using a transfer price does

not necessarily becomes a profit centre

3. Setting up an income statement for a

responsibility center does not make it a
profit centre
 Impact of transfer price on the
company accounts
 Transfer prices are not supposed to impact the company
income. It is supposed to "split" the income into
contributions for responsibility centers

BUT, in practice

 They can affect income :

 By pushing the division to sell/buy inside or outside the firm,
 In terms of taxation (when the two divisions are in different
countries)
Setting up a transfer price
2 approaches to compute transfer prices:
1. Internal cost of the transferred service
2. Transfers at market price

Cost ≤ Transfer Price ≤ Market price

 The choice will depend on the chosen procurement

policy: integration vs. diversification
 To be completed

Defining a transfer price according to

the strategy of the firm
1. Vertical integration = the supplier and the client are not allowed to
sell/buy outside the firm
- The supplier is a cost centre
- The client must take into account the costs of the supplier in its decisions
Transfer price based on the supplier costs

2. Competitive strategy = possibility to buy or sell outside of the firm

- The supplier is a profit/investment center who must be able to make

profits
Opportunity cost (S) ≤ transfer price ≤ Opportunity cost (C)
Transfer prices in real life….
1. If the transfer price is based on the supplier cost,
several options:
– full actual unit cost, full standard unit cost, rational allocation of
unit cost, marginal cost… with different consequences (not seen in
this course)

2. If the transfer price is based on the market price:

– The market price is not always known for the same type of
products/services

 This leaves space for negotiations between the supplier

and the client
 Necessity to supervise the transfer price definition in order
to avoid bargaining and ensure that performance
evaluation is fair

26
Warning
Received delegation

Financial responsibility

Type of responsibility centre

Type of transfer price

 Not the other way around…
Transfer prices - limits
1. Transfer prices do not convey information about non
financial dependences between the centres
2. Transfer prices are short-term oriented
3. Transfer prices require that the direction make decision in
a dencentralized culture
4. Some cost allocations can be discussed
5. It is hard to establish a transfer price without a precise
reference to build the measure
6. Contributions may sometimes reflect the negotiation
abilities of the managers more than their financial
performance
Responsibility centres and individual
performance evaluation
Evaluate financial
performance

RESPONSIBILITY
CENTERS
+ TRANSFER PRICES

Evaluate the
individual
performance of
managers
 To be completed

Responsibility centres and individual

performance evaluation
Evaluate financial
performance

RESPONSIBILITY
CENTRES
+ TRANSFER PRICES

Evaluate the
individual
performance of
managers

Learning and motivation

RC and managers' performance
evaluation
• The manager's performance evaluation is
said to be "objective" i.e. based on
measures and evaluated on financial
criteria

• More "subjective" evaluation criteria can be

taken into account, example of the year-end
individual performance evaluation interview

• Evaluation triggers incentives that may or

may not be financial (bonus/promotion)

• This type of evaluation has

advantages/drawbacks
 To sum up
1. Delegation requires control
2. Management control systems are used to evaluate both
managers' performance and a business unit's performance.
This can be conflictual.
3. Motivating managers requires :
To define a performance measurement system
To split responsibilities
 This is not always possible !

Transversal monitoring systems can be used(activity

based management, total quality management, supply chain
management, project management, target costing, etc.)