Managerial Accounting: Types of Responsibility Centers
Responsibility centers are identifiable segments within a company for which individual managers have accepted authority and accountability. Responsibility centers define exactly what assets and activities each manager is responsible for.
How to classify any given department depends on which aspects of the business the department has authority over.
Managers prepare a responsibility report to evaluate the performance of each responsibility center. This report compares the responsibility center’s budgeted performance with its actual performance, measuring and interpreting individual variances. Responsibility reports should include only controllable costs so that managers are not held accountable for activities they have no control over. Using a flexible budget is helpful for preparing a responsibility report.
Revenue centers usually have authority over sales only and have very little control over costs. To evaluate a revenue center’s performance, look only at its revenues and ignore everything else.
Revenue centers have some drawbacks. Their evaluations are based entirely on sales, so revenue centers have no reason to control costs. This kind of free rein encourages Al the concession manager to hire extra employees or to find other costly ways to increase sales (giving away salty treats to increase drink purchases, perhaps).
Cost centers usually produce goods or provide services to other parts of the company. Because they only make goods or services, they have no control over sales prices and therefore can be evaluated based only on their total costs.
One way for a cost center to reduce costs is to buy inferior materials, but doing so hurts the quality of finished goods. When dealing with cost centers, you must carefully monitor the quality of goods.
Profit centers are businesses within a larger business, such as the individual stores that make up a mall, whose managers enjoy control over their own revenues and expenses. They often select the merchandise to buy and sell, and they have the power to set their own prices.
Profit centers are evaluated based on controllable margin — the difference between controllable revenues and controllable costs. Exclude all noncontrollable costs, such as allocated overhead or other indirect fixed costs, from the evaluation. The beautiful thing about running a profit center is that doing so gives managers an incentive to do exactly what the company wants: earn profits.
Classifying responsibility centers as profit centers has disadvantages. Although they get evaluated based on revenues and expenses, no one pays attention to their use of assets. This scenario gives managers an incentive to use excessive assets to boost profits.
For managers, the upside of using more assets is the resulting increases in sales and profits. What’s the downside? Well, nothing; managers of profit centers aren’t held accountable for the assets that they use.
This flaw in the evaluation of profit centers can be addressed by carefully monitoring how profit centers use assets or by simply reclassifying a profit center as an investment center.
You could call investment centers the luxury cars of responsibility centers because they feature everything. Managers of investment centers have authority over — and are held responsible for — revenues, expenses, and investments made in their centers. Return on investment (ROI) is often used to evaluate their performance.
To improve return on investment, the manager can either increase controllable margin (profits) or decrease average operating assets (improve productivity).
Using return on investment to evaluate investment centers addresses many of the drawbacks involved in evaluating revenue centers, costs centers, and profit centers. However, classification as an investment center can encourage managers to emphasize productivity over profitability — to work harder to reduce assets (which increases ROI) rather than to increase overall profitability.