BEP and CVP Analysis 

Break-even point
 Is the point in the volume of activity where the organization’s revenues and expenses are equal

Sales 250,000
Less: variable expenses (150,000)
Contribution margin 100,000
Less: fixed expenses 100,000
Net Income 0
 CM per unit in peso = Selling price per unit – Variable cost per unit
 CM ratio = CM/Sales
 Breakeven point in units = fixed cost/ CM per unit
 Breakeven point in peso = fixed cost/ CM Ratio

Safety Margin
 Difference between budgeted sales revenue and breakeven sales revenue
 Amount by which sales can drop before losses occur.
 Margin of safety in units = Sales units – Breakeven point units
 Margin of safety in peso = Sales – Breakeven point
 Margin of safety ratio = Margin of safety/ Sales


Sales mix
 More than one product
 Relative combination in which a company’s products are sold.
 Different products have different selling prices, cost structures, and contribution margins.
 Weighted contribution = CM/ % of total units
 weighted average unit contribution margin = sum of weighted contribution
 Break even point = fixed expenses/ weighted average unit contribution margin
 Individual sales = breakeven point * % of total units

Assumptions underlying CVP Analysis

 Selling price is constant throughout the entire relevant range.
 Costs are linear over the relevant range.
 In multi-product companies, the sales mix is constant.
 In manufacturing firms, inventories do not change (units produced = units sold)
Cost Structure and Operating Leverage
 The cost structure of an organization is the relative proportion of its fixed and variable costs.
 Operating leverage is the extent to which an organization uses fixed costs in its cost structure.
Greatest in companies that have a high proportion of fixed costs in relation to variable costs.
 A measure of how a percentage change in sales will affect profits.
 Degree of operating leverage = CM/ Net income
 Percentage of Income increase = DOL * percentage of increase in sale

 An activity-based costing system provides a much more complete picture of cost-volume-profit

relationships thus, it provides better information to managers

 Overhead costs like setup, inspection, and material handling are fixed with respect to sales volume
but they are not fixed with respect to other cost drivers. This is the fundamental distinction between
a traditional CVP analysis and an activity-based costing CVP analysis.

Activity Based Costing

Traditional Costing Systems
 Typically use one rate to allocate overhead to products
 This rate was often based on direct labor dollars or direct labor hours
 This made sense, as direct labor was a major cost driver in early manufacturing plants.

Costs based on timing of matching with revenues

Product cost Period Cost
 Direct labor  Administrative expense
 Direct materials  Sales expense
 Factory overhead
Appear on the income statement when goods are Appear on the income statement in the period
sold, prior to that time they are stored on the incurred
balance sheet as inventory
Costs assigned to products until they are sold Costs incurred and recognized based on time
 Goods not yet completed – WIP periods.
inventory  Operating expenses like rent, salaries,
 Good completed – FG inventory and other administrative and general
 Goods sold – COGS expenses.
What are the costs that we include as product Is there a proper segregation of payroll as to
costs that in turn becomes an inventoriable costs, laborers and payroll as to office staff?
and becomes COGS when sold to customers? Is there a proper segregation of factory facility
rent and office rent?
What costs shall be reviewed that should be
included as product costs rather than as period
 costs and vice-versa?

Problems with Traditional Costing System

 Manufacturing processes and the products they produce are now more complex.
 This results in over-costing or under-costing
o Complex products are not allocated an adequate amount of overhead costs.
o Simple products get too much.
 Today’s Manufacturing Plants
o Are more complex
o Are often automated
o Often make more than one product
o Use small amount of direct labor making direct labor a poor allocation base for factory
overhead.
 When the manufacturing process is more complex
o Then multiple allocation bases should be used to allocate overhead expense.
o In such situations, managers need to consider using Activity Based costing (ABC)

Activity Based Costing (ABC)

 Activity Based Costing is an approach for allocating overhead costs
 An activity is an event that incurs costs.
 A cost driver is any factor or activity that has a direct cause and effect relationship with the resources
consumed.

ABC Steps
 Overhead cost drivers are determined
 Activity cost pools are created
o An activity cost pool is a pool of individual costs that all have the same cost driver.
 All overhead costs are then allocated to one of the activity costs pools.
 An overhead rate is then calculated for each cost pool using the following formula:
o Costs in activity cost pool/base
o The base is the cost driver.
 Overhead costs are then allocated to each product according to how much of each base the product
uses.
 OH rate = costs in activity cost pool/ base

When do we use ABC?

 When one or more of the following conditions are present:
o Product lines differ in volume and manufacturing complexity
o Product lines are numerous and diverse, and they require different degrees of support
services
o Overhead costs constitute a significant portion of total costs.
 o The manufacturing process or number of products has changed significantly – for example,
from labor intensive to capital intensive automation.
o Production or marketing managers are ignoring data provided by the existing system and are
instead using “bootleg” costing data or other alternative data when pricing or making other
product decisions.

Additional Uses of ABC

 Activity Based Management
o Extends the use of ABC from product costing to a comprehensive management tool that
focuses on reducing costs and improving processes and decision making.
 ABM classifies all activities as value-added or non-value-added
o Value-added activities increase the worth of a product or service to the customer.
 E.g. addition of a sun roof to an automobile
o Non-value added activities don’t.
 E.g. the cost of moving or storing the product prior to sale.
 The objective of ABM
o To reduce or eliminate non-value related activities (and therefore costs)
o Attention to ABM is a part of continuous improvement of operations and activities

Common Classification System

 Unit-level activities
o Activities performed for each unit of production
 Batch-level activities
o Activities performed for each batch of products
 Product-level activities
o Activities performed in support of an entire product line
 Facility-level activities
o Activities required to sustain an entire production process.
 This system provides a structured way of thinking about relationship between activities and the
resources they consume.
 Facility Sustaining Activities
o Have no good cost driver
o May or may not be allocated to products depending upon the purpose for which the
information is to be used.
o E.g. housekeeping and factory yard maintenance

Manufacturing Systems
 Traditional
o “Just-incase”
 Inventories of raw materials are maintained just in case some items are of poor
quality or key suppliers don’t deliver on time
o Push approach manufacturing
  Materials are purchased through the manufacturing process
o Based on standard costs. Once a standard is reached improvement ceases.
 Progressive
o “Just in Time”
 Raw materials arrive just in time for use in production.
 Finished goods are manufactured just in time to meet customers need.
o Pull approach manufacturing
 Raw materials are not put into process until the next department requests them.
o Continuous quality improvement.
o Three important elements must exist for JITS systems to work:
 Dependable suppliers who can deliver on short notice.
 Multiskilled workforce who can work in work cells or work stations.
 One worker may operate several kinds of machines.
 Total quality management. Objective is no defects.
o Objectives of JIT
 Reduction or elimination of inventories
 Enhanced production quality
 Reduction or elimination of rework costs

Standard Cost Accounting and Variance Analysis

Standard Cost Accounting
 Primary purpose is to control costs and promote efficiency.
 This system is used in conjunction with other costing methods.
 Based on predetermined rates
 Any deviation can be quickly detected and responsibility pinpointed so that appropriate action may
be taken.

Control of Costs
 Stability of costs does not necessarily indicate efficiency
 Comparison of actual costs to standard, rather than to historical cost, will help control costs and
promote efficiency.
 Standard costs are usually determined for a period of one year and are revised annually.

Types of Standards
 A standard is a norm against which the actual performance can be measured
o Ideal standard – a standard that a company sets in which they meet their maximum degree
of efficiency. Does not take inefficient conditions into consideration.
o Attainable standard – includes factors such as lost time and normal waste spoilage.
Standard Cost Procedures
 Standard costs are determined for the three elements of cost – direct materials, direct labor, and
factory overhead.
 The standard costs, the actual costs, and the variance between the actual and standard costs are
recorded in appropriate accounts.
 Significant variances are analyzed and investigated and appropriate action is taken.

Determining Standards – Materials and Labor

 Materials cost standard
o Determined based on the production engineering department’s estimate of the amounts
and types of materials needed.
o Cost is based on the purchasing agent’s knowledge of suppliers’ prices.
 Labor cost standard
o Time-study engineers will establish the time necessary to perform each operation
o Human resource department will provide the prevailing wage rates.

Determining Variances
 A variance is the difference between the actual and the standard costs of materials, labor, and
overhead.
 The difference may be in usage and in prices
 Materials Price Variance
o Indicates the difference between actual and standard unit cost times the actual quantity of
materials used.
o MPV = (AP – SP) * AQ
 Material Quantity Variance
o Represents the difference between actual quantity of materials used and standard quantity
allowed times the standard unit cost of materials
o MQV = (AQ-SQ) * SP
 Labor Rate Variance
o Indicated the difference between actual and standard labor rate times the actual hours
worked
o LRV = (ALR – SLR) X AH
 Labor Efficiency Variance
o Represents the difference between actual quantity of labor worked and standard quantity
allowed times the standard rate per hour.
o LEV = (AH – SH) * SLR
 

Accounting for Variances

1. Work in Process xx
Materials Quantity Variance xx
Materials Price Variance xx
Materials xx
To record the entry for direct materials cost

2. Work in Process xx
Labor Rate Variance xx
Labor Efficiency Variance xx
Payroll xx
 To record the entry for direct labor cost

3. Work in Process xx
Applied Factory Overhead xx
To record the entry applying factory overhead to work in process

4. Finished Goods xx
Work in Process xx
To record the entry for finished goods at standard cost

Disposition of the Variances

 Prorate the variances to COGS, WIP, and Finished Goods in proportion to the standard materials,
labor, and overhead costs included in the ending balances for those accounts.
 Close the variance entirely to COGS for the period
 If production varies greatly, set up a deferred changers or credits on interim balance sheets, and
dispose of at year end using one of the above methods.
 If sue to abnormal circumstances, charge off as extraordinary gains or losses on the income
statement.

Analysis of Variances
 Possible reasons for materials price variance
o Inefficient purchasing methods.
o Use of a slightly different material that the standard called for.
o Increase in market price.
 Reasons for materials usage variance.
o Materials were spoiled or wasted.
o More materials were used as an experiment to upgrade the quality of the product.

Features of Standard Costing

 an actual unit cost of manufacturing a product is not determined – only the total cost
 even though based on estimates, standards may be very reliable.
 Standards must change as conditions change.
 Standards provide incentives to keep costs and performance in line with predetermined
management objectives.
 Recording variances, helps focus management’s attention on prices paid and quantities.
 

 Applying factory OH to work in process

Work in process xx
Applied Factory Overhead xx
 Transfer finished goods
Finished Goods xx
Work in Process xx
 Record actual factory overhead
Factory OH (actual) xx
Various credits xx

Factory Overhead – Determining Standard Costs

 Involves estimation of factory overhead at the standard level of production taking historical data and
future changes into consideration.
 Standard cost is applied to Work in Process based on number of units produced.
 Factory overhead is debited with actual costs and credited with standard costs.

Two-Variance Method
 Divides the total variance into two parts
o Controllable variance
 The amount by which the actual overhead costs differ from the standard overhead
costs for the attained level of production.
o Volume variance
  The difference between budgeted fixed overhead and the fixed overhead applied to
work in process.


Four-Variance Method
 Recognizes two variable cost variances and two fixed cost variances.
 Cost variances
o Variable overhead spending variance
o Variable overhead efficiency variance
 Fixed cost variances
o Fixed overhead budget variance
o Fixed overhead volume variance

Three-Variance Method
 Separates actual and applied overhead into three variances
o Budget variance or spending variance
o Capacity variance
o Efficiency variance
 Not as common as two variance methods but frequently used by manufacturers.
Pricing and Profitability Analysis
Demand and Supply
 Holding all else equal, in a competitive market, customers will buy more at lower prices and less at
higher prices.
 Factors affecting demand:
o Consumer income, Price relative to purchasing power
o Quality of goods offered for sale, Product durability
o Availability of substitutes
o Demand for complementary goods

Demand determinant of price

 Nature of demand. Lower price, higher demand, vice versa. Higher price, supply increases.

Cost determinant of price. Type of cost.

 Variable cost
o cost that varies with changes in the level of output
 Fixed cost
o Cost that does not change as output is increased or decreased.

Dynamic pricing and yield management system (YMS)

 Dynamic pricing: ability to change prices very quickly in real time
o aids brick-and-mortar retailers to compete more efficiently with online alternatives.
 Yield Management System (YMS)
o Uses complex mathematical software to profitably fill unused capacity by
 Discounting early purchases
 Limiting early sales at discounted prices and overbooking capacity

Price Elasticity
 Measured as the percentage change in quantity dived by the percentage change in price
 If demand is relatively elastic, a small percent change in price will lead to a greater percent change in
quantity demanded. Demand is elastic if a price increase has a large negative impact on sales
volume.
 Inelastic demand is when a buyer's demand for a product does not change as much as its change in
price. 



Price
 Amount that is given up in exchange to acquire a good or service
 Effects: Measure of sacrifice and Information cue
 Importance to managers
o Revenue: price charged to customer multiplies by the no. of units sold
o Profit: revenue minus expenses

Pricing objectives
 Need to be specific, attainable, and measurable
 Categories
o Profit oriented
o Sales oriented
o Status quo

Marker Structure
Control over No. of firms Types of goods barriers
price
Perfectly None Many small Identical, homogenous Very low Easy No special
Competitive firms, not unique entry and exit expenses
thousands
Monopolistic Some Many small Similar but with Low Advertising,
firms, some unique features, coupons, cost of
hundreds differentiation
Oligopoly A lot Few or tens Same or different. fairly High, cost Cost of
unique related differentiation,
barrier rebates, coupon
Monopoly Total One Very unique Very high Legal and
lobbying expen.

Steps in setting the right price on a product

 Establish pricing goals
 Estimate demands, costs, and profits
 Choose a price strategy to help determine a base price
 Fine-tune the base price with pricing tactics
 Results lead to the right price

Cost and Pricing policies

1. Cost-based pricing. Prices are established using cost plus markup
i. Markup is a percentage applied to base cost; it includes desired profit and any costs not
included in the base cost
ii. Markup on COGS = (Selling and administrative expenses + Operating Income)/ COGS
iii. Markup on DM = (DL + OH + Selling and administrative expenses + Operating Income)/
Direct Materials
2. Target costing and pricing. Influenced by market conditions. Sets the cost of a product/service based
on the price that customers are willing to pay.
i. Target costing involves much more upfront work than cost-based pricing.
ii. If the cost-plus pricing turns out to be higher than what customers will accept additional
work or lost opportunity will result.
3. Other pricing policies
i. Penetration pricing. Pricing of a new product at a low initial price to build market share
quickly
i. Not ordinary predatory pricing because it is not meant to destroy competition
ii. Requires a higher volume of sales to reach break-even point
iii. Increased sale can justify production expansion or the adoption of new technologies
ii. Price skimming. Higher price is charged when a product or service is first introduced.
i. High introductory price, coupled with heavy promotion.
iii. Price gouging. Occurs when firms with market power price products too high.
iv. Predatory pricing. Practice of setting prices below cost for the purpose of injuring
competitors and eliminating competition. Also called dumping on the international market.
v. Price discrimination. Refers to the charging of different prices to different customers for
essentially the same product.
i. Robinson-Patman Act of 1936 prohibits
1. Firms from selling similar commodities at different prices to two or more
different buyers within a short time
2. Sellers from offering two buyers different supplementary services
3. Buyers from using their purchasing power to force sellers into granting
discriminatory prices or services.
4. Defenses provided for a seller charged with price discrimination
a. Cost
b. Market conditions
c. competition
vi. Status quo pricing a.k.a. competition pricing. Charging a price identical to or very close o
the competition’s price. Advantage is simplicity. Ignores demand or cost or both.
vii. Price fixing. Agreement between two or more firms on the price they will charge for a
product.
viii. Outcome-based pricing. Based on perceived value not on costs.
ix. Market-based pricing. Set according to current market prices for the same product.
x. Value-based pricing. Strategy of setting prices primarily based on a consumer’s perceived
value. Customer-focused pricing
xi. Pocket price. Price customers pay according to an invoice.

 Price waterfall. Pricing waterfalls are classic tools used to measure the various steps of how the
price for a product cascade down to the pocket margin, also referred to as NET or NET 3
margins. These most commonly align with how retailers identify the various contributors to their
margin.
 

Measuring Profit
 Profit. A measure of the difference between what a firm puts into making and selling a product or
service and what it receives.
 Reasons for measuring profit
o Determine the capability of the firm
o Measure managerial performance
o Determine whether or not a firm adheres to government regulations.
o Signal the market about the opportunities for others to earn a profit.


Absorption Costing Approach to Measuring Profit
 Also called full costing
 Required for external financial reporting
 Assigns all manufacturing costs, DM, DL, Variable OH and a share of fixed overhead to each unit of
product
o Each unit of product absorbs some of the fixed manufacturing OH in addition to its variable
manufacturing costs

Advantages Disadvantages
 Price covers all costs
 Perceived as equitable
 Comparison with competitors
 Used for external reporting
o

Variable Costing Approach to Measuring Profit

 Also called as direct costing
 Assigns only unit level variable manufacturing costs to the product – theses costs include direct
materials, direct labor, variable overhead
 Fixed overhead is treated as a period cost and is not inventoried with the other product costs – it is
expensed in the period incurred.

If Then

Production > sale Absorption-costing income > variable costing

income

Production < sale Absorption-costing income < variable costing

income

Production = sale Absorption-costing income = variable costing

income

Limitations of profit measurement

 Focus on past performance
 Uncertain economic conditions
 Difficulty of capturing all important factors in financial measures

Successful firms measure far more than accounting profit

 Impact on the community
 employees

Analysis of Profit Related Variances

1. Sales price and sales volume variances
a. Sales price variance = (Actual price – Expected price) * quantity sold
b. Sakes volume variance = (actual volume – expected volume) * expected price
 c. Overall sales variance = sales price variance + sales volume variance
2. Contribution margin variance
a. Contribution margin variance = annual contribution margin – budgeted contribution margin
b. Contribution margin volume variance = (actual quantity sold – budgeted quantity sold) *
budgeted average unit margin
3. Sales mix variance
4. Market share variance
a. Market share gives the proportion of industry sales accounted for by a company.
b. [(actual market share % - budgeted market share %) * (actual industry sales in units)] * budgted
average unit contribution margin
5. Market size variance
a. Market size is the total revenue for the industry

Product Life Cycle

 Describes the profit history of the product according to four stages
o Introduction
o Growth
o Maturity
o Decline
 Helps the firm understand the different competitive pressures on a product in each stage

Customer Profitability
 Customer profitability (CP) is the profit the firm makes from serving a customer or customer group
over a specified period of time, specifically the difference between the revenues earned from and
the costs associated with the customer relationship in a specified period.
 Customer profitability analysis makes use of the following formula to determine profitability: Total
profit per customer = Total annual revenue generated - Total costs incurred.
 Customer profitability analysis allows you to segment your customers by their profit contribution to
your brand and optimize your marketing, customer service, and operations costs around the
customer segments who are the most profitable for your brand.

Consumer penalty
 Extra fee paid by the consumer for violating the terms of the purchase agreement
 Businesses impose penalties when
o They suffer irrevocable revenue loss
o They incur significant additional transaction costs if customers are unable or unwilling to
complete their purchase obligations.

Budgeting
 Profit planning refers to the short-term setting of goals and objectives on how to become profitable
 There is a need to plan and budget resources to determine how to properly maximize these
resources for the attainment of the entity’s goals and objectives.
  Budgeting now comes as a highly important factor in planning business operations

What is budgeting?
 Budgeting is the process where an entity translates their operations in quantitative terms to
represent it as its planned operations, activities, and production for a specific time period in
consideration
 Budgeting helps in:
o Planning operations
o Controlling operations
o Cost management

Objectives of budgeting
 A budget should be able to provide a realistic estimate of income and expenses
 A budget should provide a coordinated plan of action for the entity
 A budget should serve as a control mechanism that can be used in performance evaluation by being
able to check results and suggest future corrective actions.
 A budget should provide guidance to the management
 A budget should help in decision-making
 A budget should be able to improve communication, coordination, and harmonious operations
within the entity.
 Budgeting helps in planning, performance evaluation, coordination, control, motivation, and
promoting positive behavior.

Benefits of budgeting
 It compels managers to think ahead
 It provides an opportunity to reevaluate existing activities and evaluate new ones
 It aids managers in communicating objectives and coordinating actions across the organization.
 It provides benchmarks to evaluate subsequent performance.

Master Budget
 A master budget is regarded as a comprehensive financial planning tool that highlights operating
budgets, budgeted financial statements, and a financial plan.

Operating Budget Financial budget

 A budget plan dedicated to the  A budget plan dedicated to the entity’s
operations of the entity such as sales, cash budget, budgeted financial statements, an
production, and operating expenses capital acquisitions.
 Sales budget  Capital budget
 Production budget  Capital acquisition budget
 Purchases budget Budgeted financial statements
 Direct labor budget  Balance sheet
 Overhead budget  Income statement
 Cost of sales budget  Cash flows
 Operating expenses budget  Retained earnings
 Budgeted income statement



Sales budget
Schedule of cash collections

Production budget
Direct materials budget

Schedule of cash disbursements for materials

Direct labor budget

Manufacturing overhead budget

Cost of Goods Sold Budget

Will be forwarded in income statement

Selling and Administrative Expense budget

Cash budget
Budgeted Income Statement
Other budgeted schedules

Budgeted balance sheet

Responsibility Accounting
Centralized Organizations
 Centralization is a business structure in which one individual makes the important decisions (such as
resource allocation) and provide the primary strategic direction for the company
o Most small businesses are centralized in that the owner makes all decisions regarding
products, services, strategic direction, and most other significant areas.
o However, a business does not have to be small to be centralized
o Many businesses in rapidly changing technological environments have a centralized form of
management structure.
o The decisions made by the lower-level management are limited in a centralized environment
o Apple is an example of a business with a centralized management structure.
o Within Apple, much of the decision-making responsibility lies with the Chief Executive
Officer (CEO) Tim Cook, who assumed leadership role within Apple following the death of
Steve Jobs.
o Apple has long been viewed as an organization that maintains a high level of centralized
control over the company’s strategic initiatives such as:
 New product development
 Markets to operate in, and
 Company acquisitions
 The advantages of a centralized organization include:
o Clarity in decision-making
o Streamlined implementation of policies and initiatives
o Control over the strategic direction of the organization
 The primary disadvantages of centralized organizations can include:
o Limited opportunities for employees to provide feedback
o A higher risk of inflexibility

Decentralized Organizations
 Decentralization is a business structure in which the decision-making is made at various levels of the
organization. Typically, decentralized businesses are divided into smaller segments or groups in order
to make it easier to measure the performance of the company and the individuals within each of the
sub-groups.
o In order to be successful, a company must work hard to develop strategic competitive
advantages that distinguish the company from its peers.
o The organizational structure must allow the organization to quickly adapt and take
advantage of opportunities.
o Many organizations adopt a decentralized management structure in order to maintain a
competitive advantage.
 Advantages
 o Quick decision and response times – decisions made and implemented in a timely manner.
In order to remain competitive, it is important for organizations to take advantage of
opportunities that fit the organization’s strategy.
o Better ability to expand company – it is important for organizations to constantly explore
new opportunities to provide goods and services to its customers
o Skilled and/or specialized management – organizations must invest in developing highly
skilled employees who are able to make sound decisions that help the organization achieve
its goals.
o Increased morale of employees – the success of an organizations depends on its ability to
obtain, develop, and retain highly motivated employees. Empowering employees to make
decisions is one way to help increase employee morale.
o Link between compensation and responsibility – promotional opportunities are often linked
with a corresponding increase in compensation. In a decentralized organization, a
compensation increase often corresponds to a commensurate increase in the
responsibilities associated with learning new skills, increased decision-making authority, and
supervision of other employees.
o Better use of lower and middle management – many tasks must be performed in order to
achieve success in an organization. Decentralized organizations often rely on lower and
middle management to perform many of these tasks. This allows managers to gain valuable
experience and expertise in different areas.

Benefits of Decentralization
Supporters of decentralizing decision making claim the following benefits from granting responsibilities to
managers of subunits:
1. Creates greater responsiveness to the needs of a subunit’s customers, suppliers, and employees. Good
decisions cannot be made without good information. Compared with top managers, subunit managers are better
informed about their competitors, suppliers, and employees, as well as about local factors that affect performance,
such as ways to decrease costs, improve quality, and better respond to customers. Flextronics, a global supply
chain solutions company, uses decentralization to reduce bureaucracy and increase responsiveness. Managers can
use the company’s worldwide information technology to solve a local customer’s problem or send a project to
other managers without going through red tape.
2. Leads to gains from faster decision making by subunit managers. Decentralization speeds decision making,
creating a competitive advantage over centralized organizations. Centralization slows down decision making
because the decisions must be pushed upward through layer after layer of management before they are finalized.
Interlake Mecalux, a leading provider of materials-handling solutions and storage products, cites this benefit of
decentralization: “We have distributed decision- making powers more broadly to the cutting edge of product and
market opportunity.” Interlake’s storage system solutions must often be customized to fit the needs of
customers. Delegating decision making to the sales force allows Interlake to respond faster to changing customer
requirements.
3. Assists management development and learning. Subunit managers are more motivated and committed when
they can exercise initiative. Moreover, giving managers more responsibility helps a company develop an
experienced pool of talent to fill higher-level management positions and weed out people unlikely to be successful
top managers. According to Tektronix, an electronics company based in Oregon, “Decentralized units provide a
training ground for general managers and a visible field of combat where product champions can fight for their
ideas.”
4. Sharpens the focus of subunit managers and broadens the reach of top management. In a decentralized
setting, the manager of a subunit has a concentrated focus. The head of Yahoo Japan, for example, can develop
country-specific knowledge and expertise (about local advertising trends, cultural norms, payment forms, and so
on) and focus on maximizing Yahoo’s profits in Japan. At the same time, this relieves Yahoo’s senior managers at its
Sunnyvale, California, headquarters from the burden of controlling day-to-day operating decisions in Japan. They
can spend more time and effort on strategicplanning for the entire organization.

Costs of Decentralization
Advocates of more-centralized decision making believe decentralizing is costly because it does the following:
1. Leads to suboptimal decision making. If the subunit managers do not have the necessary expertise or talent to
make major decisions, the company, as a whole, is worse off because its top managers have relinquished their
responsibility for doing so. Even if subunit managers are sufficiently skilled, suboptimal decision making—also
called incongruent decision making or dysfunctional decision making—occurs when a decision’s benefit to one
subunit is more than offset by the costs to the organization as a whole. This is most prevalent when the subunits of
the company are highly interdependent, such as when the end product of one subunit is used or sold by another
subunit. For example, suppose Nintendo’s marketing group receives a rush order for additional Wii consoles in
Australia following the release of some popular new games. A manufacturing manager in Japan who is evaluated
on the basis of costs may be unwilling to arrange this rush order because altering production schedules invariably
increases manufacturing costs. From Nintendo’s viewpoint, however, supplying the consoles may be optimal, both
because the Australian customers are willing to pay a premium price and because the current shipment is expected
to stimulate future orders for other Nintendo games and consoles.
2. Leads to unhealthy competition. In a decentralized setting, subunit managers may regard themselves as
competing with managers of other subunits in the same company as if they were external rivals. This pushes them
to view the relative performance of the subunit as more important than the goals of the company. Consequently,
managers may be unwilling to assist other subunits (as in the Nintendo example) or share important information.
The 2010 Congressional hearings on the recall of Toyota vehicles revealed that it was common for Toyota’s Japan
unit to not share information about engineering problems or reported defects between its United States, Asian,
and European operations. Toyota has since asserted that it will change this dysfunctional behavior.
3. Results in duplication of output. If subunits provide similar products or services, their internal competition
could lead to failure in the external markets. The reason is that divisions may find it easier to steal market share
from one another, by mimicking each other’s successful products, rather than those of competing firms.
Eventually, this leads to confusion in the minds of customers and the loss of each division’s distinctive
strengths. A classic example is General Motors, which eventually dissolved its Oldsmobile, Pontiac, and Saturn
divisions. Similarly, Condé Nast Publishing’s initially distinct food magazines Bon Appétit and Gourmet eventually
ended up chasing the same readers and advertisers, to the detriment of both. Gourmet magazine stopped
publication in November 2009.2
4. Results in duplication of activities. Even if the subunits operate in distinct markets, several individual subunits of
the company may undertake the same activity separately. In a highly decentralized company, each subunit may
have personnel to carry out staff functions such as human resources or information technology. Centralizing these
functions helps to streamline and use fewer resources for these activities and eliminates wasteful duplication. For
example, ABB of Switzerland, a global leader in power and automation technology, is decentralized but has
generated significant cost savings of late by centralizing its sourcing decisions across business units for parts, such
as pipe pumps and fittings, as well as engineering and erection services. Having subunits share services such as
information technology and human resources is becoming popular with companies because it saves 30–40% of the
cost of having each subunit purchase these services on its own.

Responsibility Accounting
 Refers to an accounting system that collects, summarizes, and reports accounting data relating to the
responsibilities of individual manager. A responsibility accounting system provides information to
evaluate each manager on the revenue and expense items over which that manager has primary
control (authority of influence).
 Decentralized organizations use a responsibility accounting system to tie together lower-level
managers’ decisions with accountability for the outcome of those decisions. In a responsibility
accounting system, lower-level managers have decision-making authority, but they are also
accountable for the effect on business that their decisions have.
 Responsibility accounting is a system that involves identifying responsibility centers and their
objectives, developing performance measurement schemes, and preparing and a analyzing
performance reports of the responsibility centers.
 Responsibility Accounting is an underlying concept of accounting performance measurement
systems. The basic idea is that large diversified organizations are difficult, if not impossible to
manage as a single segment, thus they must be decentralized or separated into manageable parts.
These parts, or segments are referred to as responsibility centers.

Fundamental aspects of responsibility accouting

 Inputs and outputs or Cost and Revenues
o The physical resources utilized in an organization; such as quantity of raw material used
and labor consumed, are termed as inputs. These inputs expressed in the monetary
terms are known as costs.
o Similarly, outputs expressed in monetary terms are called revenues. Thus, responsibility
accounting is based on cost and revenue information.
 Planned and Actual Information or use of budgeting
o Effective responsibility accounting requires both planned and actual financial
information
o It is not only the historical cost and revenue data but also the planned future data which
is essential for the implementation of responsibility accounting systems
 o It is through budgets that responsibility for implementing the plans is communicated to
each level of management
o The use of fixed budgets, flexible budgets and profit planning are all incorporated into
one overall system, of responsibility accounting.
 Identification of Responsibility Center
o The whole concept of responsibility accounting is focused around identification of
responsibility centers. The responsibility center represents the sphere of authority or
decision points in an organization.
 Relationship between Organizational Structure and Responsibility Accounting System
o Responsibility accounting system should parallel the organizational structure and
provide financial information to evaluate actual results of each individual responsible for
a function.
 Assigning costs to individuals and limiting their efforts to controllable costs
o After identifying responsibility centers and establishing authority-responsibility
relationships, responsibility accounting system involves assigning costs and revenues to
individuals. Only those costs and revenues over which an individual has a definite
control can be assigned to him for evaluating his performance.
 Performance Reporting / Performance Measurement
o Responsibility accounting system is focused on performance reports also known as
responsibility reports
o The reports should contain information in comparative form as to how plans (budgets)
and the actual performance and should give details of variances which are related to
that center.
o The variances which are not controllable at a particular responsibility center should also
be mentioned separately in the report. To be effective, the reports should be clear and
simple.
 Participative management
o The function of responsibility accounting system becomes more effective if participative
or democratic style of management is followed, wherein, the plans are laid or
budgets/standards are fixed according to the mutual consent and the decisions reached
after consulting the subordinates.
 Management by exception
o An effective responsibility accounting system must focus attention of the management
on significant deviation and not burden them with all kinds of routine manners.
 Human aspect of responsibility accounting
o to ensure the success of responsibility accounting system, it must look into the human
aspect also by considering needs of subordinates, developing mutual interests,
providing information about control measures and adjusting according to requirments.

Responsibility Centers
Recall (from Chapter 6) that a responsibility center is a segment or subunit of the organization whose manager is
accountable for a specified set of activities. To measure the performance of subunits in centralized or
decentralized companies, the management control system uses one or a mix of the four types of responsibility
centers:
1. Cost Center —the manager is accountable for costs only.
 A cost center is a department or function within an organization that does not directly add
to profit but still costs the organization money to operate
 Contributes to company’s profitability indirectly through
i. Operational efficiency
ii. Customer service
iii. Increasing product value
 Managers of costs centers such as human resources and accounting departments are
responsible for keeping their costs in line or below budget and does not bear ay
responsibility regarding revenues or investment decisions.
 Any associated benefits or revenue-producing activities of these department are
disregarded for internal management purposes.
 Help management utilize resources in smarter ways by having a greater understanding of
how they are being used.
 Include company’s
i. Accounting department
ii. Information technology
iii. Maintenance staff
iv. Quality control
v. Customer service center
 How to measure
i. Cost per unit. Since a cost center manager is responsible for costs, cost per unit
produced or supplied is an obvious measure. A simple way to calculate this is to
divide the costs incurred in a period by the units produced in the period
ii. Efficiency, capacity utilization, and production volume ratios. These relate to the
use of time (and hence labor costs) in the center. When setting a budget for a cost
center, it is normal to specify how long it should take to produce each item
(standard hours per unit) and how many hours the factory to expected in work.
2. Revenue and Profit Center —the manager is accountable for revenues only. the manager is accountable
for revenues and costs.
 A revenue center is a responsibility center where a manager would only be accountable for
the generation of revenues with no control over costs.
 A profit center is a responsibility center where a manager is responsible for generating
revenues, while also planning and controlling costs and expenses.
 A profit center is a branch or division of a company that directly adds to the corporation’s
bottom-line profitability.
 A profit center is treated as a separate business, with revenues accounted for on a stand-
alone basis.
 Profit centers are crucial to determining which units are the most and the least profitable
within an organization.
  The managers or executives in charge of profit centers have decision -making authority
related to product pricing and operating expenses
 Managers also face considerable pressure as they must ensure that their division’s sales
from products or services outweigh the costs – that their profit center produces profits year
after year, either by increasing revenue, decreasing expenses, or both.
 Examples
i. Individual restaurants in a large restaurant chain
ii. Manufacturing divisions in a large retail chain
iii. Individual retail stores in a large retail chain
iv. Local branches in a regional or nationwide distribution business
v. Other organizational subunit deliberately established to maximize the profits of the
subunits
vi. Any other department or subunit where profitability can be measured by matching
revenues with costs
 How to measure
i. Profit compared to budget. Profit centers will usually have budgets to work to so
this simple comparison is very useful.
ii. Profit per unit. Profit per unit produced or supplied, calculation is divide the profit
for a period by he units produced in the period.
iii. Gross profit percentage
iv. Net profit percentage
v. Expenses over sales. These can be useful ratios to see if expenses (Such as
administration expenses) are keeping in line with sales.
3. Investment Center—the manager is accountable for investments, revenues, and costs.
 Is a business unit in a firm that can utilize capital to contribute directly to a company’s
profitability
 Companies evaluate the performance of an investment center according to the revenues it
brings in through investments in capital assets compared to the overall expenses.
 An investment center is a center that is responsible for its own revenues, expenses, and
assets, and manages its own financial statements which are typically a balance sheet and an
income statement. Because costs, revenue, and assets have to be identified separately, an
investment center would usually be a subsidiary company or a division.
 Examples
i. Division of a large organization
ii. Branch offices of banks
iii. Subsidiary companies
iv. University campuses
v. Business units
 One can classify an investment center as an extension of the profit center where revenues
and expenses are measured. However, only in an investment center are the assets employed
also measured and compared to the profit made.
 How to measure
 i. Return on investment. Earnings divided by investment
ii. Residual income. Earnings minus expected target return
iii. Economic value added. After tax earning minus cost of capital.
 Each type of responsibility center can be found in either centralized or decentralized companies.
A common