Responsibility Centres

BLOCK

2
MANAGEMENT CONTROL STRUCTURE
UNIT 4
Responsibility Centres 73
UNIT 5
Cost Centres 111
UNIT 6
Profit Centres 137
UNIT 7
Investment Centres 185
UNIT 8
Transfer Pricing 238

71
Management
Control Structure BLOCK 2 MANAGEMENT CONTROL
STRUCTURE
In the first block we had discussed about the basic concepts of management
control and management control systems. In the second block we are going to
discuss about the management control structure. This block consists of four
units.

Unit 4 gives an introduction of the Responsibility Centres which are the

organizational units that are central to the management control process. A
responsibility centre is any organization unit headed by a manager who is
responsible for its activities. In this unit we discuss about delegation and how
delegation leads to creation of the responsibility centres. Later, in the unit we
discuss about the various type of responsibility centres, procedure for
establishment and performance evaluation of the responsibility centres.

Unit 5 deals with the concept of Cost Centres/Expense Centres which are
the organisational units which are responsible for cost control. There are two
types of cost centres viz. engineered cost centres and discretionary cost
centres. Two main techniques from accounting point of view used for cost
control are zero base budgeting and activity based cost accounting

Unit 6 deals with the concept of Profit Centres, which is a type of the
responsibility centre. In profit centre, the management control system is
concerned with the measurement of both input (expense) and output
(revenue) in monetary terms. The difference between the two is profit. The
scope of profit centre is much broader than that of other type of responsibility
centres and the managers of these centres have responsibility and authority to
make decisions that effect both costs and revenues.

Unit 7 deals with the concept of Investment centre. In an investment centre

the control system not only measures the revenue and expenses but also
measures the investment base on which these revenues are earned. The sum
of these assets is termed as investment base.

Unit 8 deals with the Transfer pricing. An organization may have many
divisions producing goods and services, which are being consumed in-house
by other divisions. The question, which needs to be answered, is how to
price these goods and services. This unit deals with the various aspects of
transfer price.

72
UNIT 4 RESPONSIBILITY CENTRES Responsibility Centres

Objectives

After studying this unit, you should be able to:

• appreciate the relationship between Strategy, Structure, and Management

Control;
• understand the concept of Responsibility Accounting and Responsibility
Reporting and their importance for Management Control;
• understand the criteria for the establishment of various responsibility
centres and distinguish between them;
• appreciate, understand and distinguish between two types of cost centres
and their organizational significance; and
• explain the concepts of Management by Exception, Variances and
Controllability of costs.

Structure
4.1 Introduction
4.2 Strategy, Structure and Management Control
4.3 Delegation of Authority
4.4 Responsibility Accounting
4.5 Responsibility Centres
4.6 Establishment of Responsibility Centres
4.7 Performance Evaluation of Responsibility Centres
4.8 Designating unit as Responsibility Centres
4.9 Management by Exception
4.10 Variances: Their Meaning and Significance
4.11 Responsibility Accounting: An Illustration
4.12 Summary
4.13 Key Words
4.14 Self-assessment Questions
4.15 References
4.16 Further Readings

4.1 INTRODUCTION
The purpose of this Unit is to familiarize you with the concepts of
Responsibility Accounting and Responsibility Centres which are fundamental
to the Management Control System in a large organization with several
units/segments. Delegation of authority and assignment 108 of responsibility
is a basic necessity in such organizations. The unit first explains the concepts 73
Management of Responsibility Accounting and Responsibility Centres, and the rationale
Control Structure
behind the establishment of responsibility centres. The relationship between
responsibility centres and the organization structure is examined. The unit
then attempts to explain the various responsibility centres: Cost Centres;
Revenue Centres; Profit Centres; and Investment Centres. This is followed by
a discussion of the criteria for appropriately designating various
Responsibility Centres. The unit then takes up the two types of cost centres:
Engineered Cost Centres and Discretionary Cost Centres and explains them
in considerable detail, including some special type of discretionary cost
centres where measurement of output and performance is mired in
difficulties. The unit concludes with a discussion on Management by
Exception; the meaning and significance of Variances; and Controllability of
costs. Towards the end, the concepts of responsibility accounting and
reporting are illustrated through an example.

4.2 STRATEGY, STRUCTURE AND

MANAGEMENT CONTROL
A strategy lays down the general directions in which an organization plans to
move to attain its goals. Every well managed organization has one or more
strategies, although in some cases they may not be explicitly stated. A firm
develops (or should develop) its strategies by matching its core competencies
with industry opportunities. Figure 4.1 schematically lays out the
development of a firm’s strategies.

Figure 4.1: Strategy Formulation

Source: Anthony, R.N. and Govindrajan, V. 1998, Management Control Systems, Tata
McGraw Hill: 54.

Strategically, a firm may chose to limit itself to a single industry (with one or
74 more products within the same industry), or it may extend its activities into
different but related industries, pursuing a strategy called Related Responsibility Centres
Diversification, or it may extend its activities to different and unrelated
industries, pursuing a strategy called Unrelated Diversification.

In fact, there is a continuum from one extreme to the other, and most of the
companies can be found at one or the other point of this continuum,
depending on the extent and type of diversification they have chosen to
follow.

Strategy in general determines the organization structure of the firm. Single

industry firms tend to be functionally organized and have functional
structures (they are at the one extreme of the continuum) with senior
managers responsible for developing the company’s overall strategy to
compete in its chosen industry as well as its functional strategies in such
areas as research and development, manufacturing and marketing.
However, all single industry business firms may not necessarily be organized
on functional basis. If the business units are organized geographically (i.e.,
the firm is a multi-location company, e.g., fast food chains, hotels,
supermarkets, drugstores, etc. are all single industry firms, but are organized
by business units), they have both production and marketing functions at
various locations.

In unrelated diversification, which is at the other extreme of the continuum,

the firm is organized into relatively autonomous (or semi-autonomous)
business units established on the basis of various industries (or industry
groups or products) they are in. Such a structure is known as a product
based divisional structure. With a large and diverse set of businesses, the
corporate managements in such companies tend to focus on portfolio
management (i.e., selection of businesses in which to engage and allocation
of financial resources to various business units) with delegation of authority
to develop product/market strategy, to the general managers of business units.
Thus, while at the single industry end, the senior managers are likely to have
good familiarity of the industry in which the firm competes and have
expertise in many areas (manufacturing, marketing, finance, R&D, etc.), the
corporate managements in highly diversified companies (also called
conglomerates) may not have familiarity with the competitive situation of
various industries, not to speak of the expertise in the matters of such
industries. Their primary expertise tends to be in finance and overall control.

The case of companies with related diversification falls between these two
extremes, and they have product-based structures which partake some of the
characteristics of both the two extremes.

As the firm moves from the single industry end to the unrelated diversified
end, the autonomy of the business unit manager tends to increase for two
reasons. First, unlike the single industry firm, corporate managers of
unrelated diversified firms generally lack the knowledge and expertise to
make strategic and operating decisions for desperate business units. Second,
75
Management there is very little interdependence across business units in a firm with
Control Structure
unrelated diversification. Contrary to this, there may be considerable
interdependence between the business units of a firm with limited
diversification or of a single industry firm, as the business units, by and large,
belong to the same industry or industrial classification. Generally, the size of
the corporate staff in a firm with unrelated diversification is smaller than the
size in single industry firm, or a firm with related diversification. While many
of the administrative and support activities in the latter firms tend to be
located at the top management level, in the former firms they tend to be
located at the business unit level.

In the large multi-industry enterprises with divisions operating in diverse and

unrelated industries, it was found that the central office in general tended to
be small one, concerned, by and large, with overall control and coordination.
Their role was found limited to periodical monitoring and review of
performance, futuristic planning and resource allocation. Many of the service
departments were decentralized. Contrary to this, in companies with no or
little diversification (and also in holding companies), the central office tended
to be large and multi-functional, with a pool of multi-talent expertise.

The above discussion clearly shows the influence of strategy on the structure
of the organization. That is why, it has been said that structure follows the
strategy. But howsoever the structure may be aligned with the strategy; the
chosen strategy cannot be implemented without a consistent management
control system. While organization structure defines the reporting
relationships and the authority and responsibility of various managers, its
effective functioning depends on the design of an appropriate control system.
For instance, corporate level managers in a highly diversified company
cannot be expected to control different businesses in the absence of intimate
knowledge of such businesses. Further, there is no or little interdependence
between the units. Business units are more or less fully independent. Hence,
the evaluation of such businesses tends to be based on the concept of
portfolio management (just as it happens in the case of a holding company).
Contrary to this, in single industry firms and firms with limited
diversification, the top management may possess companywide core
competencies on which strategies of most of the units are based. Further,
often there may be considerable interdependence existing between the
business units. Hence, whereas the control system in highly diversified firms
should emphasize the encouragement of competition and entrepreneurial
spirit, the control system in firms with limited diversification should stress on
promotion of cooperation with healthy competition.

By the way, in addition to the functional structure, product divisional

structure, and conglomerate (or holding company form), there is another
structural form known as Matrix structure where the product (or business)
divisional form is overlaid on the functional structure to from a matrix or
grid, resulting in dual authority for most of the members of the organization.
76
The combining of the two forms usually results in a compromise between Responsibility Centres
functional specialization and line-of-the-business specialization. For
organizations which work in a dynamic or fast changing environment and
‘where competition is intense, matrix form is considered appropriate. The
business unit managers and resource managers in a matrix structure have
important strategic responsibilities. The team approach implicit in such a
structure is capable of accommodating differing viewpoints and perspectives.
There are several well known companies, such as General Electric, Texas
Instruments, Boeing, Dow Coming, etc. that use matrix structures. Since
matrix form is likely to generate some conflict and misunderstanding, it must
be carefully designed. It is a complex structure to manage and has important
management control implications.

4.3 DELEGATION OF AUTHORITY

Delegation of authority and assignment of responsibility are almost inevitable
in today’s large and complex organizations. There are several ways in which
responsibility for decisions may be established and authority delegated
throughout the organization. Responsibilities may be established by
functional areas (production, marketing, finance, etc.); by geographical basis
(countries, regions, etc); and by products (refrigerators, air-conditioners,
home appliances, computer components, etc.). In large organizations, the
responsibilities may be divided on the basis of one of these functional areas.
For example, an organization might make a division of responsibilities first
on the basis of different groups of products. Each product group might further
be divided on functional basis. And, finally, the responsibilities within one
function, say marketing, may be divided on a geographical basis. Whatever
the method for dividing responsibilities, it is important that each manager is
delegated the authority and resources to carry out the responsibilities s/he
assumes.

This process of dividing responsibility and delegating authority provides

opportunities for less experienced managers to gain decision making
experience in the areas of their competence. Through new assignments within
the organization, the scope of decision making competence grows, giving the
individual a chance to prepare for positions of increased responsibility. This
opportunity is important both for the individual and the organization.

How decision making authority and responsibility is delegated, is important

to the management (and the finance and management control function)
because it influences (i) who shall receive reports; (ii) what these reports will
contain; and (iii) how frequently those reports will be prepared.

Along with the responsibility and authority, there is usually a degree of

accountability. To attain this objective, a system must be established to report
accomplishments by responsibility so that performance can be measured.
This is how the system of Responsibility Accounting came into being.
Responsibility accounting is the mechanism through which managers
77
Management communicate with sub-ordinates in order to maintain control over the
Control Structure
segments of the business for which they are responsible.

All the activities in an organization cannot be fulfilled by a single person or

Manager. To meet the targets or deadlines the Manager should delegate the
tasks assigned to him, to his subordinates. Delegation is about shifting or
passing on your responsibilities to your subordinates for optimum results.

Elements of delegation involve authority, responsibility, and accountability.

Fig. 4.2: Elements of Delegation

Authority is the right to give orders, commands, and instructions to the

subordinates and the scope has to be well defined. The chain of flow is
always from top to bottom. This explains the fact that always the authority
delegates his work to the subordinate while clearly instructing or defining the
work/task to be completed. Delegating the work does not imply that you are
absolved of the responsibility or accountability for the job. The accountability
still lies with the authority.
The person held responsible for a task is expected to complete it in all
respects maintaining the quality within the timeline. Based on the completion
of the task he is evaluated and is either praised for completion or answerable
for not meeting the expectations.
Accountability involves ownership for any variations or gaps in not meeting
the expectations. Accountability cannot be delegated. Though a manager
may delegate his task to his subordinate, the accountability to complete the
task per guidelines within the defined timeline, still lies with the Manager.
Any deviations or shortfalls, the manager is answerable to his superiors.

78
 Responsibility Centres

4.4 RESPONSIBILITY ACCOUNTING

Responsibility Accounting is a widely practiced management accounting and
control system in the business world. The system results in the preparation of
accounting statements for all levels of management, designed primarily so
that they can be effectively used by the operating managers as a tool in
controlling their operations and costs.“By definition it is a system of
accounting which is tailored to an organization so that costs are accumulated
and reported by levels of responsibility within the organization. Each
supervisory area in the organization is charged only with the cost for which it
is responsible and over which it has control.”

Responsibility Accounting (RA) is a system which recognizes various

responsibility or decision centres within the organization and traces costs,
revenues, or/and resources to individual managers who are primarily
responsible for making decisions about them.3 The various responsibility
centres that could be established are:

• Cost centres, which could either be Engineered cost centres or

Discretionary cost centres
• Revenue centres
• Profit centres
• Investment centres.

In responsibility accounting the accounting system is designed or tailored in

such a way that —

i) It traces the inputs, outputs and resources (i.e., costs, revenues and
assets) to the managers who are primarily responsible for their decisions;
ii) The process yields a measurement of the financial effects of the activities
that the managers are responsible for; and
iii) It provides meaningful feedback to the segment managers, enabling self-
control by comparing actual performance with the plans formulated.

Responsibility accounting requires a specific and precise recognition of the

individual areas of responsibility specified by the firm’s organization
structure. RA in essence is a communication system which is designed to aid
an enterprise in achieving its costs and profit goals. Within this communication
system, extreme care must be taken to make sure that planning and
measurement revolve around the areas of responsibility. In the words of
Anthony and Reece, “RA is that type of Management Accounting that
collects and reports both planned and actual accounting information in terms
of responsibility centres.” Anthony regards the emergence of RA as an
important landmark in the history of accounting and management control. In
the literature on accounting and management control, the classification of
79
Management inputs, outputs and resource data along with responsibility lines has been
Control Structure
stated to be one of the most important classification schemes.

Though certain principles have evolved over the years (which we will be
talking about as we proceed) which can be applied to ensure an effective RA
system, it must be stated that RA is more of a general concept than a precise
technique. The particular systems that have been developed to serve the RA
purpose may be as varied and as unique as the complexity and diversity of
large business enterprises. However, one thing is clear; each particular RA
system represents the efforts of the management (or the financial function) to
modify traditional accounting practices to emphasize information useful to
operating management, and not just accounting data which may not be
pertinent for operating decisions.

The RA system is particularly relevant in multi-product business

organizations where the authority for business segments has been delegated
and the need exists to monitor the performance of these segments on a regular
basis. The process of delegation is called “decentralization” as discussed in a
previous unit. What is important to understand is that whereas under the
traditional system the corporate entity is managed as a whole as a “portfolio”
of several business activities, under the system of RA the control and
monitoring of separate business activities (segments) is carried out on an
ongoing and regular basis.

The RA approach makes possible the operation of a good budget system. No

budget system can be fully effective unless it is built around the basic
philosophy that each responsible individual in an organization must feel that
the budget is his budget and not something imposed upon him which he
might feel is unrealistic and unworkable. Unless he feels that it is his budget,
he will make only a superficial attempt to live within it or achieve what is
expected.

In fact, the system of RA personalizes the accounting statements by saying,

“Arvind, this is what you originally budgeted and this is how you performed
for the period with actual operations as compared against your budget.” The
emphasis, unlike in cost accounting (where the emphasis is on knowing the
product cost), is on controlling costs at the centres where they are incurred.

For modem multi-product business enterprises, a simple and straightforward

system is necessary for corporate survival and growth. In response to the
needs of such business enterprises, the management systems that have been
developed rest on three principal elements:

Delegation to successive lower organizational levels the responsibility for

Specific goals which are necessary to achieve the objectives of the enterprise.

Motivation of management in charge of each operating unit to perform in

accordance with the established goals, and

80 Measurement of the progress of efforts towards achieving the specified

goals. Responsibility Centres

In this respect RA as a concept is part of the total management system.

Therefore, the system must be linked to the financial planning, measuring,
and reporting systems and also to the organization structure of the business.

Organization Structure

The backbone of any RA system is the organization chart. Three fundamental

steps must be taken in order to have an effective RA system that will meet the
needs of a decentralized organization:

1) Responsibility for all revenues and cost must be assigned to individuals

in the organization.
2) A structure of accounting for revenues and cost must be put in place
which will capture and accumulate these items according to the
organizational responsibilities as assigned.
3) A system for comparing accumulated revenues and costs with relevant
targets by responsibility centres must be designed and implemented.
An illustration of how responsibility accounting system operates is provided
towards the end of this unit.
The assignment of responsibilities should parallel closely to the organization
structure. An RA system which does not reflect the realities of the
organization structure is likely to be ineffective.
Although the responsibility for cost control should be assigned specifically to
organizational units capable of controlling costs, this is easier in concept than
in practice because many costs are jointly controlled, either by separate units
at the same level or to varying degrees by higher organizational levels.
Special arrangements for assigning responsibility are necessary in these
situations. Generally, costs can be assigned to organizational units based on
the degree of control. In other situations, the solution may not be so readily
apparent. However, methods have been evolved to allocate or apportion such
costs to the various units on a reasonably fair basis. Out of these methods,
one which seems most suitable has to be chosen for application.
Similarly, in many large enterprises various organization units provide
services or products to other units, Under RA system a charge may be made
for these services or products to the benefiting units on some rational basis. A
system of transfer pricing is required which would be discussed in unit 8.
However, it will suffice to say that numerous methods are available to charge
for such services or products to the benefiting units.

In addition to the RA system being based on the organization structure, it

should be integrated with other financial systems in a way that permits
control of performance through measurement by responsibility.
81
Management Why Responsibility Accounting?
Control Structure
Responsibility accounting complements a management system which some
years ago held its sway in the management world for more than two decades.
It generated a substantial body of literature during this period. It is called
Management by Objectives (MBO) where the budget, instead of being a
symbol of pressure is a document/instrument of self-control (by all
responsible members of the organization). This implies a motivation not only
towards self-control but also the knowledge about the norms of control in the
individual situation. How can an intelligent manager control his operations if
s/he does not know explicitly what is expected of him and how well s/he is
doing? As far as cost control is concerned, s/he needs to know two things: (i)
what his/her costs should be; and (ii) what his/her costs were/are? It is the
function of the budget to provide the first set of information. RA will provide
the second. There are a number of similarities between MBO and RA.

4.5 RESPONSIBILITY CENTRES

Organizations must align to the vision and function as goal congruent
entities. While organization sub units perform for organization goals, the
functions performed by each vary. Consequently, the deliverables for each
subunit in the organization vary. In this chapter, we identify these subunits,
popularly known as responsibility centres, and identify the roles, functions,
and performance measures of each of the responsibility centres in an
organization.

An entity can function only when there is a collective responsibility.

Responsibility centre can be viewed as an “organizational segment”
(Caraiani C., Dumitrana M., 2005). Each of the organizational segments has a
specific set of aggregate tasks to be performed. Mere performance of tasks
can, at best, be execution. The difference between executing a set of tasks
and being responsible for delivery would rest in the fact that the set of people
who engage themselves in obtaining the results have a certain decisional
autonomy. Responsibility centres generate their reports and submit them to
the management to be viewed in sync with the organization’s reports. These
responsibility centres can be classified as Profit Centres (responsible for
profits), Cost centres (with minimizing cost objectives), Revenue centres
(with target revenues), and Investment centres (responsible for investments
and revenues).
Let us take the simple example of any IT industry say Tata Consultancy
Services (TCS) as an organization and analyze the responsibility centres
therein. The Clients for whom TCS has done IT implementation are situated
all over the globe. Hence the organization can be divided into responsibility
centres based on geography for example North America, Africa, Europe, and
Australia. The sales revenue and margins from each of these regions are
plotted separately and monitored as a separate unit. If further analysis is
required, the clients from each of these regions are identified and the
annual/monthly revenue targets are monitored along with the profit margins.
82 This helps the management to identify the region-wise profits and client-wise
profits thereby helping in management decisions on whether it is profitable to Responsibility Centres
continue business with a client or not. Again, within the client, they identify
the business line (type) whether it is a regular maintenance contract or
whether it is a new customized implementation project, and go into the
revenue, cost, and margin of each of these contracts. This will further help in
identifying whether a particular project with a client is viable or not. While
overall there may be profit generation with a client, sometimes it could so
happen that one of the projects is in loss whereas the profit is contributed by
other projects. So this detailed analysis helps in maximization of profits.

To maximize the organization’s efficiency and performance, Ionaşcu I., Filip

A.T., Stere M., (2007) propose a three-tier structure in organizations:
i) Top of the hierarchy with managers in charge of the strategy;
ii) At the base, are the operational staffs that carry out operational tasks?
iii) An intermediary link between the top and the base, namely,
responsibility centres,

In a manufacturing company, for instance, the lowest level of the hierarchy

might be the workshops or production units. These units are responsible for
production or output. At the higher levels are departments or Strategic
Business Units that consist of the smaller units, staff, and management. They
are usually responsible for middle management functions such as budgeting,
marketing, and human resource management. At the level of senior
management and the Board of Directors, they are responsible for the
functioning of the whole enterprise.
The mechanism of responsibility accounting is designed to control
expenditures by directly relating the reporting of expenditures to the individuals
in the company/organization who are responsible for their control.

The management has to decide as to what range of discretion and influence

the managers of different responsibility centres would be allowed with
respect to revenues, costs, and investments.

A responsibility centre (RC) is an organizational unit that is headed by a

manager who is responsible for its activities. In a sense, a company is a
collection of responsibility centres, each of which is represented by a box on
the organization chart. These responsibility centres form a hierarchy. At the
lowest level in the organization are responsibility centres for sections, work
shifts, or other small organization units. At higher levels are departments or
business units which consist of several of these smaller units plus staff and
management people; these are also responsibility centres. From the
standpoint of senior management and the board of directors, the whole
company is a responsibility centre, although the term is generally used to
refer to units within the company.

Why Responsibility Centres?

We just indicated that the organization is a sum of its responsibility centres.
Every organization has its objectives and goals which percolate down to the
responsibility centres. As such, every responsibility centre has also its goals 83
Management which are derived from the overall goals of the organization. The purpose of
Control Structure
responsibility centres is to facilitate the accomplishment of objectives and
goals of the [Link] shown in Figure 4.3 every responsibility centre
has a task to perform. It uses inputs in the form of resources (material, labour,
equipment, and other assets and uses variety of services). With these
resources, the responsibility centre performs its assigned task, and produces
outputs which may be described as goods, if they are tangible, or services, if
they are intangible. It should be remembered that every RC does something
and it has its outputs. While the outputs in a production plant are goods, the
outputs of service units such as HRM, transportation, accounting and finance,
and administration are services. The difference is only in the nature of output.
While the output in the form of goods is easily measurable, it is not so in the
case of services; nevertheless, outputs do exist.

Depending on the nature of the organization whether it is primarily a

manufacturing organization or a service one, the outputs produced by a RC
may be furnished either to another RC (internal customer) or to the outside
marketplace (external customers). While in the first case, the outputs become
inputs to another RC; in the latter case, they are outputs of the whole
organization which take the form of revenues.

Inputs Outputs
Responsibility Centre
Resources used Task performed Products
Materials Services
Labour
Capital, etc.

Figure 4.3: Schematic Representation of a Responsibility Centre

We will now discuss the various types of responsibility centres. The various
responsibility centres are shown diagrammatically in figure 4.4

Cost
Centres Engineered
Cost
Centres

Responsibility Cost
Centres Centres
Discretionary
Cost
Centres
Cost
Centres

Cost
Centres

Fig. 4.4: Responsibility Centres

84
Cost Centre Responsibility Centres

The business segments are classified as cost centres, if the responsibility is

for cost control alone. The manager has no authority over investment or
revenue in his unit, but does have authority to effectively control the amount
of costs incurred. The unit manager is essentially responsible for minimizing
costs subject to some output constraints. In other words, in a cost (or
expense) centre, inputs or expenses are measured in monetary terms, but
outputs are not measured that way. An example of a cost centre is the
maintenance department which does not “charge” other units for its services
and thus has no revenues.

In the cost centre, though the total performance of the manager depends on
how effectively and efficiently the output (whatever it may be) is achieved,
but the financial performance is measured by whether the assigned or agreed
tasks have been accomplished within the budgeted amounts of costs.

At times, though, a difference is made between “cost centre” and “expense

centre”, we shall use the terms synonymously. For instance, it has been stated
that an expense centre is a responsibility centre and it has a manager, whereas
a cost centre may not have an identifiable manager. For example, a machine
may be cost centre, if costs are accumulated separately for the machine. Here,
the machine is merely an accounting entity and is not based on the
responsibility accounting concept. For expenses like maintenance cost,
insurance, light or air-conditioning, though costs are accumulated on item
basis, but no particular manager is responsible for such costs. Under the
system of RA, whether we call a unit a cost centre or an expense centre, it
must be borne in mind that it is an organization unit which is headed by a
responsible manager. Only then it can become a responsibi1ity centre.
Cost centres can be of two types:
(i) Engineered cost centres, and
(ii) Managed or Discretionary cost centres.
This will be explained later in Unit 5. Let us first explain briefly the other
responsibility centres.
Revenue Centre

The revenue centre is responsible for generating revenue for the company by
selling goods or services. This centre is responsible for initiating the revenue
for the organization. Again, in our above example of TCS, there are separate
sales teams who establish the relationship with the client, explain to them
about the IT products/services offered by the organization and in what way it
would be different to build a relationship with them instead of others in the
market. The sales value or revenue of a project is arrived at taking into
consideration the various costs involved and the period for delivering the
project. Once the sales order is bagged, it is the delivery team’s responsibility
to implement/ deliver the project. In this sales activity, the sales expenses are
monitored separately with the help of the accounting team.

85
Management
Control Structure
For the manager of an organizational segment whose primary responsibility
is marketing, the segment may be designated as a revenue centre. The
marketing department is an example of a revenue centre whose outputs are
measured in terms of sales revenue along with a primary responsibility for
producing target revenue; a revenue centre often has an additional
responsibility for controlling marketing expenses. The focal points of revenue
control are:
(i) sales volume of units of product;
(ii) product price (for certain marketing segments, the authority to fix
prices may not be delegated); and
(iii) the proportion or mix in which the various products of the company
are sold.
A revenue centre manager would be concerned with things like market share,
marketing expenses, advertising and market research, customer relationship,
average collection period, delivery schedules, travel and entertainment,
training and motivation of the sales force, etc. Marketing problems vary so
widely from one company to the other that no standard system can be
specified. In a revenue centre, financial performance is measured by whether
the segment has achieved budgeted levels of sales revenue, with a secondary
concern about the relationship of the actual expenses incurred to the
expenses planned in achieving the revenue generated. The manager of the
revenue centre is expected to balance the various marketing means used to
achieve the revenue plan, but cannot balance production expenses which are
not a part of the marketing managers responsibility.

Profit Centre

A profit centre is a department that directly adds to the profit of an

organization. In our above example, each client can be treated as a profit
centre. The individual profit margins for each project are calculated and
monitored monthly, to be consolidated at the client level.

An organizational segment may be designated as profit centre if the

responsibility and control that can be exercised encompasses all activities
involved in the production and sale of products, systems, or services. In other
words, the manager has control over revenues as well as costs, but does not
have control over the amount of investment in his segment. Decisions as to
the sale price, advertising strategies, and other marketing policies are made
by the profit centre manager. Decisions as to which investment projects are
accepted in his profit centre, however, are made by top management -
perhaps by a central committee.

Here, the manager has authority over both marketing and production, and he
is motivated to seek the balance which produces the best profit results. For
example, by designing and producing a higher-quality product, revenue may
increase more rapidly than expense, leading to higher profit. Suppose, there is
a rush order for shipment at a somewhat higher price. The profit centre
86 manager has to take a balanced view of the total situation. Does the potential
goodwill and added profit to be earned from this customer offset the costs Responsibility Centres
involved in revising the production schedule, working overtime, delaying
delivery to other customers, etc.? The decision has to be made by the profit
centre manager by balancing the benefits and costs, and s/he can do so
because s/he has the authority over both marketing and production, and is
motivated to seek the balance which produces the best profit outcome.

In a profit centre, financial performance is measured by whether it has

achieved its budgeted profit. It needs to be clarified that, as is always the
case, the total job of the manager will include financial and other measures of
performance. The manager might be expected to maintain the morale of the
work force, sustain a research programme, carry out market research,
properly maintain buildings and equipment, and be responsive to the needs of
the communities in which employees reside, etc. Relevant measures have to
be evolved or established for all these other aspects of managerial
performance, but the measure of financial performance will be whether the
budgeted levels of profit were achieved.

Investment Centre

Investment centres are a part of the responsibility centre involved in utilizing

the capital directly to contribute to the profits of the organization. Different
Responsibility centres are responsible for different outcomes and the
evaluation parameters for each of them vary. For example in an IT
organization such as TCS, sometimes to breakthrough in a new geographical
location (country) they may accept a project at lower revenues that do not
meet the profit margin target of say 30%. Even with a small margin of say
5%, the management may decide to go ahead with this project keeping in
view the future benefits of bagging more orders depending on client
satisfaction. The investment ratios (profit vs total investment) are calculated
for each project and then aggregated at the client level.

In the discussion about profit centre, there was an implicit assumption that its
manager has little control over the amount of resources invested in the
segment. The magnitude of investment is primarily determined by higher
levels of management. The role of the manager is to use the resources
efficiently and effectively. But, in an investment centre the manager has
significant control over investment in assets as well as revenue and costs
incurred. The rationale here is similar to that underlying a profit centre. In
this case, however, a positive balance is needed between the profit achieved
and the resources invested in the segment. For example, requiring customers
to pay their accounts in ten days rather than allowing thirty days will reduce
the resources (working capital) invested in accounts receivable. But it might
also have an adverse effect on levels of sales and therefore on levels of profit.
The question arises: Is the benefit from reduced level of investment more
than the loss of profit from reduced sales and profit? Profit centre system will
encourage a manager to consider these questions and make the best decisions
in the interest of the organization.
87
Management
Control Structure
While the total performance of the investment centre manager for other
aspects enumerated in our discussion of profit centre above will be judged in
terms of the measures evolved, financial performance is measured by whether
or not the actual return on investment (or actual residual income - this will be
discussed in the unit on investment centres) of the segment exceeds the
budgeted levels for this measure.

Table 4.1: Examples of various type of Responsibility Centres

Financial Statement Items Statement Cost Profit Investment
Centre centre Centre
Trading and Profit & Loss Statement

Revenue X X X

Cost of goods sold X X X

Gross profit X X

Advertising X X X

Research & Development X X X

Other expenditure X X X

Corporate income tax X X

Profit before tax X X

Balance Sheet

Fixed Assets X

Current Assets X

Current Liabilities X

Long term debt X

(X indicates that responsibility centre manager is accountable for some elements included in
the financial statement)
Source: Kenneth A. Merchant "Financial Responsibility Centres". Modern Management
Control systems: Text & Cases, Pearson Education Inc. 1998.

88
 Responsibility Centres

Engineered Expense Centre Example

Optimal
relationship can
be established

Inputs Outputs
Work Manufacturing functions
In monetary Physical
units

Discretionary Expense Centre

Optimal
relationship cannot
be established

Inputs Outputs
Work Research & Development
In monetary Physical function
units

Revenue Centres
Inputs not
related to
outputs
Inputs Outputs
Work Marketing function
(Revenue in
(Only cost
monetary
directly
terms
incurred)

Profit Centre
Inputs are related
to outputs

Inputs Outputs
Work Business unit
(Cost in (Profits in
monetary terms) monetary
terms
Investment Centre

Profits are related

to capital employed

Inputs Outputs
Work Business unit
(Cost in (Profit in
monetary monetary
terms) units)

Fig. 4.5: Types of Responsibility Centres

(Adapted from Robert N. Anthony and Vijay Govindarajan. “Responsibility Centres:

Revenue and expense centres” Management Control Systems, Irwin 1995 pp 110.
Relationship between different Responsibility Centres
When the whole company is treated as a profit centre it may have one or
more expense responsibility centres. If a company has more than one profit
89
Management centre, each profit centre will have one or more expense responsibility
Control Structure
centres. It may also have a corporate expense responsibility centre to which
all expenses, which are not incurred specially for profit centre, may be
charged. For example, general administration expense of corporate office
may be charged to appropriate corporate expense responsibility centre.
Characteristics of a Responsibility Centre
An effective responsibility centre should have the following characteristics:
1) It is a clearly defined segment of an organization.
2) A designated individual is responsible for its performance; namely, the
output produced by the segment as well as inputs consumed by the
segment.
3) The designated individual has the necessary authority to discharge the
assigned responsibilities.
The usual forms of responsibility-centres in different organization vary
widely. It can be the entire company, business units, product divisions, sales
branches, sales regions, Functional departments such as production,
marketing, personnel and finance or their subdivisions.

Illustration

Designation Responsibility Centre

President Investment Centre: Responsible for all investment
decisions and hence to be evaluated on the basis of
performance of Return on Investment (ROl)
Vice-President Profit Centre :Responsibility for all the revenues and
expenses Apparels Division of the division and hence
responsible for the profits of the division; to be
evaluated on the basis of profit performance either in
terms of achievement of budgeted performance or in
terms of margin on sales
Ibis Apparels is organized with clear delegation of responsibilities. The
production manager is responsible for all the activities relating to production.
Similarly, the marketing manager is responsible for all activities relating to
the marketing of products, Vice-President; Apparel Division is responsible
for the profits of the division. However, only the president is responsible for
the investment decisions for the different divisions of the company.
The management control structure of Ibis Apparels is presented in
Figure 4.6.
President

Vice-President Vice-President
Apparel Division Other Division

Production Marketing Manager-

Manager-Apparels Apparels

Figure 4.6: Management Control Structure of Ibis Apparels

90
As presented in Figure 4.6 the management control structure of Ibis Apparels Responsibility Centres
is structured into responsibility centres as follows:

Production Expense Centre: Responsible for production and

Manager hence responsible for all the expenses to be incurred
(Apparels) for production; to be evaluated on the basis of
achievement of budgeted targets of production and
control of expenses within budgets and or a certain
inputs-output relationship.

Marketing Revenue Centre: Responsible for all the revenues of

Manager the decision; to be evaluated on the basis of
(Apparels) achievement of the budgeted targets

Activity 4

a) Try to draw the organization chart of Ibis Apparels based on the above
information relating to responsibility centres.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
b) Can you identify the four major elements to be controlled in any
organization?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
c) Can you describe different responsibility centres in terms of the major
elements to be controlled in any organization?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

It should be noted that the responsibility of the expense centre and profit
centre may be further delegated to subordinate responsibility centres. From
the above we can visualize the hierarchy of responsibility centre in case of
Ibis Apparels as
91
Management
Control Structure
Investment Centre
President

Profit Centre
Vice-President
Apparel

Expense Centre Revenue Centre

Production Marketing
Manager Apparel Manager Apparel

Figure 4.7: Ibis Apparels-Hierarchy of Responsibility Centre

4.6 ESTABLISHMENT OF RESPONSIBILITY

CENTRES
Establishment of responsibility centres in an orgnisation is not an easy task. It
must be carefully planned and executed. Some of the major steps involved in
the process can be described as follows:

l ) Study the organization structure, authority-responsibility relationships or

job descriptions, layout of the factory and office, various activities,
production process and structure of the production flows, and the
interrelationships among these different activities. Based on this study,
list all the different operations and activities, functions and tasks in the
terms.
2) Define each activity in descriptive terms,
3) Evaluate the need for any reorganization required in the context of
establishment of responsibility centres and develop an organization
structure on the lines of desired responsibility centres.
4) Delineate the organization into various responsibility centres. Ensure that
the centres so established satisfy the three characteristics of a good
responsibility centre.
The establishment of centres can be considered a tentative starting point for
evaluation against the following factors:
• The objectives of the system which will govern the number and type of
responsibility centres, the need for cost information relating to a
particular activity;
• The need for flexibility for supplying cost information for occasional
requirements;
• Ease in allocation of costs, measurement of performance and evaluation
of variances;
• Future needs of the organization at least to the extent known from
corporate or strategic plans;
• The volume of information and paperwork to be contended with;
• Segregation of production departments and service departments;
• Comparison of the planned responsibility centres with those of a similar
92
 company; and Responsibility Centres
• A system of coding of the responsibility centres for easy recording and
retrieval of information. This can also integrated with account numbers.
Activity 5
Draw up a flow chart of activities for establishing responsibility centres in an
organization with which you are familiar.
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................

4.7 PERFORMANCE EVALUATION OF

RESPONSIBILITY CENTRES
After assigning the necessary authority and responsibility to individuals at
different centres, it becomes quite necessary to undertake evaluation of their
performance. Any performance evaluation has to be done taking into account
the objectives set as well as the predetermined criteria set for them. The
objectives may be different for different responsibility centres. For example,
for expense centre, it would be minimizing cost, for revenue centre, it would
be maximizing sales revenue, for the profit centre, it would be maximizing
profits and for investment centre, it would be maximizing return on
investment.

The overall performance evaluation concept applied to various responsibility

centres is given in the following Table 4.2

Table 4.2: Various Responsibility Centres and their Performance

Evaluation

Types of Control Variable of the Variable Objective

Centres Centre Predetermined by
Top Management
Expense Prices and quantities of Prices and quantities Minimize
Centre inputs of input/budget cost
Revenue Prices and quantities of Quantities to be Maximize
Centre inputs sold/budget sales
revenue
Profit Prices and quantities of Investment Maximize
Centre inputs and outputs profit
Investment Price and quantities of inputs None Maximize
Centre and outputs and investment return on
investment

93
Management Activity 6
Control Structure
Can you enumerate major consideration in performance evaluation of
responsibility centres?
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

4.8 DESIGNATING UNITS AS RESPONSIBILITY

CENTRES
How does top management decide whether a particular unit in the
organization should be designated as a cost centre, revenue centre, profit
centre, or investment centre? There are three criteria which usually apply:

1) The factors towards which the management wishes to direct the unit
manager’s attention.
2) The factors which can be controlled by the unit manager.
3) The education, experience and competence of the typical unit manager.
We will discuss each of these criteria briefly.

Directing unit manager’s attention

In what direction the management would like to focus the unit manager’s
attention depends on the nature of the unit. For example, if it is a research
unit, the manager’s efforts should be directed towards achieving research
results as effectively as possible, and at the lowest possible cost. If it is a
production unit, the management would be interested in the manager striving to
meet product quality and delivery schedules at the lowest possible cost. In
these types of units, a cost centre would probably be most appropriate since it
directs the manager’s attention to achieving his objectives within the
budgeted cost levels.

In a situation, for example, marketing department where the manager is

responsible for generating certain level of revenue, the revenue centre is most
appropriate because it directs the manager’s attention to selling prices, sales
volume, and sales mix. The profit directs attention towards both costs and
revenues. Profit centre is particularly appropriate for a unit where the
manager has to weigh the possibility of additional revenue with the
possibility of additional cost to achieve profit objectives. S/He is motivated to
take a balanced view of the matters in the interest of his/her own unit and the
whole company.

However, where the management wants that the managers should relate the
profit of his unit with the amount invested in the unit, because s/he has the
94 authority and the flexibility in determining the quantum of investment, it
would be advisable to direct his/her attention to both these aspects. Hence, Responsibility Centres
the investment centre idea would be more appropriate.

Factors which can be controlled by the manager

Controllability, along with directing attention, is an important criterion in

deciding how a responsibility centre is to be designated. How do you decide
whether a factor is controllable? If unit manager is given authority to make
decisions which will significantly change the outcome of a certain action/
event/item, it is said that the action or item is controllable by him/her. If unit
managers can control only costs, then the unit should be designated as cost
centre. If the manager of the unit can control revenue, the designation of
revenue centre would be appropriate. If the manager can control
simultaneously revenues and the costs of producing those revenues, a profit
centre designation would be appropriate.

A note of caution seems in order; control is never absolute. For example, the
manager of a production department (as it happens in many organizations) is
considered responsible for the cost of direct labour (work force). Often,
however, s/he may have little control on the total wage bill, because wage
rates of the workers are determined by prevailing wage rates or a union
contract. Available plant and machinery may put further constraint on the
manager (as productivity of the works force depends on how advanced/
efficient the machinery is). However, it is proper to focus his/her attention on
those aspects (for instance, scheduling and overtime work) which s/he can
control, and not on those which s/he cannot control. As long as the items
which the manager can control significantly change the amount of direct
labour, the controllability criterion suggests that manager be held responsible
for production labour.

Experience and competence of the manager

This criterion is particularly important where establishment of a higher level
responsibility centre, viz., profit centre or investment centre is being
considered, because the creation of such a centre requires people with a
certain level of background in terms of education, experience and
competence level. People with required level of competence and personality
attributes may not be available in the organization. For example, the
management of an investment centre is quite a complex task. The
responsibility of investment centre manager is quite onerous. In an
investment centre, the manager would normally control costs, revenues, and
asset levels. In order to do this competently, the manager needs to have
adequate knowledge of production, marketing, finance, human relations,
legal matters and accounting, etc. If the managers with required skills and
competences are not available (in the long run, however, a solution may be
worked out either through internal or external sources), the higher level
management may decide to retain the authority to make capital
expenditure decisions to itself, or they may like to have a centralized system
95
Management of collection of accounts receivable till at least the time a manager is ready to
Control Structure
take over full responsibility. Until such time, the unit manager’s financial
performance might better be measured on a profit centre basis than on an
investment centre basis.
Since all the three above criteria are subjective, management must exercise
judgment in selecting the measure of financial performance to be applied to a
particular unit of the organization. Once decided it is the role of finance
function or management accountant to develop an accounting and reporting
system to compare the actual results with the planned results for the agreed
measure of performance. This is where RA system steps in.

4.9 MANAGEMENT BY EXCEPTION

You know that some mechanical and electronic devices sound a warning by
buzzing if some undesirable/unwanted event or happening takes place. If the
load on your inverter (when electric power trips) increases beyond a certain
permitted load level, or your car exceeds a certain speed, or a burglar intrudes
into your house, your inverter, your car, and your security device gives a
signal by buzzing so that you can take appropriate action to reduce the load
on your inverter, slow the speed of your car, or take safety measures.
Similarly, an accounting and management control system for business based
on the concept of management by exception draws the attention of the
management to areas where action is potentially required.
Management by exception is based on the premise that most of an
enterprise’s activities proceed according to plan. Since managers rarely have
enough time, they would like to concentrate their efforts in areas where
improvements are most likely. If a plan is well drawn, the most fertile areas
for significant improvements lie in the deviations from or exceptions to the
plan.

A reporting system based on the concept of management by exception assists

the manager in better allocating time. Reports should show deviations of
actual results from budgeted results. The reports illustrated in Table 4.3 are
based on management by exception principle in that variances represent
deviations from the plan or budget.

It is sometimes thought that only unfavourable deviations or variances call

for management attention. While it is natural for managers to be concerned
about unfavourable variances, favourable variances also represent real
opportunities for improvement. How a particular operating unit or a
responsibility centre has been able to achieve better than budgeted
results is a question that cannot be just wished away. What could have caused
it needs to be probed. Is it because of lax quality control, or is it because of
not meeting promised delivery schedule, or is it because of finding more
efficient means of producing output? In either case, management may find
opportunities for improvement, or may find new ideas which can be applied
to the other units or responsibility centres of the organization with
96 good results. Thus, attention to variances resulting from a management by
exception system may be productive whether actual results are worse or Responsibility Centres
better than the expected. Management’s response to unfavourable or
favourable variances depends upon their belief that the variances indicate real
opportunities for improving operations. The meaning and interpretation of
variances is explored in the next section.

4.10 VARIANCES: THEIR MEANING AND

SIGNIFICANCE
Variances are the major output of the RA system. What managers are
supposed to do when they receive reports containing variances? The
following sequence (though not necessarily all the steps at all the times) can
be helpful in their decision to react:

1) Determine whether the variance is significant.

2) If it is significant, investigate to discover the events which caused the
variance.
3) Depending on the cause, take action to change future operating
conditions or to replan with a resulting change in the standard or budget
so that this variance will not recur from the same cause in future unless
the corrective action was ineffective.

We explain these three steps briefly.

Significance of Variance

Howsoever meticulously drawn, a plan cannot be exact, and hence every

single deviation from the plan may not call for management action. Not every
variance can be expected to be significant in the sense that it calls for
investigation and management action. For example, a revenue budget may be
planned by using an average expected price per unit. But many minor
discounts and other variations in average price, warranted by the circumstances,
may occur during a year. Any of these revenue variations will lead to
variance. But not all are worth the time and expense of investigation and
management action.

The nature of the planning activity should lead us to think in terms of ranges.
The significant variances are those which fall outside some predetermined
range. How does one establish this range? How great must a variance be
before it falls outside this range and is considered significant? There are three
essential factors which must be taken together in reaching this decision.
1) The absolute amount of the variance.
2) The size of the variance relative to the planned total amount of revenue
or expense.
3) The pattern of these relative variances over time.

Absolute Amount of Variance

97
Management If the absolute variance amount is not large, the expense of investigating to
Control Structure
find the cause of variance might exceed the long term saving resulting from
its elimination.

Relative Size of Variance

The size of the variance relative to the planned total amount (standard or
budget) for a particular expense or revenue may give additional insights.
Even if the variance amount in absolute terms may appear to be quite
significant, in relative terms it may still be small, and, therefore, not justify
investigation and the time required to be spent on it. Usually, a
variance is the result of a combination of causal factors, many of which are
small random variations which tend to average out over a reasonably long
period. During any short period, there is some chance of random variations
combining either on the unfavourable or favourable side and result in a
variance which, in total, appears significant. If none of the random factors
can be controlled economically, the time and expense devoted to the
investigation is not worth. The aim should be to investigate variances where
there is good probability of a non-random causal variable large enough to
make corrective action worthwhile. But how does one decide whether a
certain percent variance is random or non-random. The answer would depend
on the nature of the production process (whether it involves considerable
wastage - as in the case of a foundry - vs. negligible wastage)
and the value/cost of the raw material or components used (e.g., high-value
components assembled into finished products).
Pattern of Variance
One should look at the pattern of past variances to determine the permissible
or cut off percentage or range for a particular operation.

Investigation of Causes and Management Action

When a variance is found to be significant, the next step is to determine its

causes. The latter would indicate what action would be appropriate. In
general, revenue variances result from price, volume or mix differences, or a
combination of these factors. A mix difference occurs in a company with
several products, each with a different contribution margin. A favourable mix
variance occurs when more of higher-contribution-margin products are sold
relative to lower-contribution-margin products.

Expense variances result either from differences between the planned and
actual prices paid for the items, or from the differences between the planned
and actual use of the various items of materials or components. While the use
of more raw material than planned would result in unfavourable usage
variance, more prices paid for raw material than planned would give rise to
unfavourable price variance. In either case, when management has
determined the event that caused the variance, a judgment is made as
to the appropriate action.
98
Putting the things in perspective: In the above discussion, we have been Responsibility Centres
talking about cost control, particularly in relation to cost centres. However,
the things need to be put in the proper context.

1) The variances that we have discussed above mostly measure efficiency,

rather than effectiveness. Efficiency is measured by comparing actual
costs incurred (inputs) with the standard allowable costs of output (or as
provided for in the flexible budgets). Effectiveness, in the context of the
subject we have been talking about, is measured by comparing the actual
quality produced with the quantity planned for.

2) It must be said that costs do not control operations; people control costs
of operations. It should also be remembered that head of the finance and
control function, by whatever name called-Controller, Management
Accountant, or Finance Manager - does not control costs or people,
except in his own department. The control of costs must be exercised by
line management; the controller assists line management by collecting,
analyzing and reporting cost information to management. Behavioural
considerations are highly important in controlling costs and in using
costs as a means of controlling operations. It should be mentioned that
the key to control of operations is motivation of people which should be
kept in mind at all times when considering costs as a means of
controlling operations.

Further, the costs should not be perceived merely in the manufacturing

context. Cost should be interpreted as the cost of doing something, and that
something may not be a product all the times; it may be a service. When costs
are viewed as costs of doing something, it becomes much easier to utilize
them in controlling operations because it is obvious that people are
responsible for doing things, and cost control can be achieved only through
motivation of the people. Costs are fixed or variable, direct or indirect,
controllable or non-controllable because people made them that way by their
decisions.

Before any cost control system can be designed and used for the development
and growth of an operation, management objectives and goals must be
defined. A careful evaluation of the objectives and goals will facilitate the
development of information/reporting system under RA.

4.11 RESPONSIBILITY ACCOUNTING: AN

ILLUSTRATION
To see how such a system operates and to keep the discussion at a simple
plane, we will consider just a small manufacturing organization which, let us
assume, has earlier completed its planning for the current year and has
incorporated plans into budgets for all levels of the firm. The organization of
the firm is presented in Figure 4.8.

99
Management
Control Structure General
Gautam
Manager

Marketing Production Pradeep

Manager Manager

Fabrication Assembly Amar

Department Department

Figure 4.8: New age Manufacturing Company Organization Chart*

The New Age Manufacturing Company is organized functionally, with a

marketing manager and a production manager reporting to the general
manager. On the production side, the Fabrication Department, the Assembly
Department, and the Production Department are designated as Cost (or
Expense) Centres. The Marketing Department, in all likelihood, will be
evaluated as a revenue centre. The General Manager is presumably
responsible for production, marketing, finance, and all other functions of the
firm, which would be measured as a profit or investment centre. However,
here, to keep the illustration on a simple plan, we shall focus only on the
expense side of his/her responsibilities.

New age manufactures and sells helmets for scooter/mobike riders. It

manufactures and sells 40,000 helmets or so a year throughout India and
exports some to neighbouring countries. Fabrication Department consists of
nearly 60 workers and is overseen by Feroz. Material and labour standards
have been established, as have flexible budgets for planning amounts to be
spent on various fabrication activities, including rework of materials
and cleanup. Amar supervises the Assembly Department. Standard costs for
parts and labour, and a flexible budget for other costs, including rework,
supplies and cleanup, etc. have been established. Pradip supervises Feroz and
Amar, coordinates deliveries and production scheduling with the marketing
manager, and purchases all the material for the manufacture of helmets. The
General Manager, Gautam, coordinates marketing and production, and
handles financial and other matters at the overall level.

100
The New age Manufacturing Company Responsibility Centres
Departmental Expense Summary (Gautam)
(Over) or Under
Budget Budget
This Year to This Year to
month Date Month Date
Controllable Expenses
Office (Including rent, etc.) Rs. 325 1700 Rs. 20 Rs (45)
Production 342 1687 (6) 2
Marketing 226 1130 (5) 13
Total Rs. 893 4517 Rs. 9 Rs. (30)

Standard Variance
This Year to This Year to
Month Date Month Date
Direct labour Rs. 1363 6863 Rs. (1)P 30
41Q 46
Direct materials 1507 7732 171P (25)
(1995)Q (165)

The New age Manufacturing Company

Production Expense (Pradeep)
(Over) or Under
Budget Budget
This Year to This Year to
month Date Month Date
Controllable Expenses
Office Rs. 80 380 Rs. (5) Rs (5)
Fabrication 151 810 10 (7)
Assembly 111 497 (11) 14
Total Rs. 342 1687 Rs. (6) Rs. 2

Standard Variance
This Year to This Year to
Month Date Month Date
Direct labour Rs. 1363 6863 Rs. (1)P 30
41Q 46
Direct materials 1507 7732 171P (25)
(1995)Q (165)

The New age Manufacturing Company

Fabrication Expenses (Feroz)
(Over) or Under
Budget Budget
This Year to This Month Year to
month Date Date
Controllable expenses
Saw sharpening Rs. 65 Rs. 310 Rs. (2) 3
Repair and rework 40 270 12 (10)
101
Management Cleanup 46 230 0 0
Control Structure
Total Rs. 151 810 Rs. (10) Rs. 7

Standard Variance
This Year to This Month Year to
Month Date Date
Direct labour Rs. 904 4552 Rs. (20)P 21
46Q 31
Direct materials 411 2069 21 14
Hours per hour Rs. 2.2 2.2 Rs. (0.05) 0.01
Table 4.3: The New age Manufacturing Company Responsibility Reports,
Departmental Relationship

The responsibility control reports and the departmental relationships they

represent are set forth in Table 4.3. Each successively higher level in the
organization is responsible for an increasingly wider scope of operations. The
responsibility reporting (RR) system reflects this by integrating direct
material and labour into the production manager’s controllable expense
budget for the Fabrication and Assembly Departments. At the highest
level, the General Manager’s controllable and direct manufacturing expenses
include expenses incurred in both production and marketing, reflecting the
broader scope of the General Manager’s responsibilities. Other parts of the
General Manager’s reports (not shown) would depict revenues, and income
statement, and a statement of financial position to portray the profits and
return on investment being achieved.

The arrows indicate the relationship between the reports of fabrication

manager, Feroz, production manager, Pradip, and general manager, Gautam.
This relationship is perhaps the most important thing to be noted. As the
responsibilities broaden, so do the items included in the expense centre
reports.

A few aspects of the reports are important to understand. First, the reports are
divided into two main sections: controllable overheads and direct material
and labour. The reason for this that a flexible budget system is the
appropriate reporting system for the overhead items listed in controllable
overhead expenses. A standard cost system is the appropriate reporting
system for direct materials and direct labour. One difference between the two
is that the standard cost system breaks the variances into price and quantity
components.

The flexible budget for overhead items does not break out a price and
quantity component. Rather, the detail is by expense type such as repair and
rework, cleanup, etc., illustrated in Feroz’s fabrication report. The report
shows the expense situation for the current month as well as for the year to
date. As the year progresses, the two types of amounts permit better
assessment of the trend of expenses in the various units of the organization.

The report also presents budgeted amounts and variances from budget. The
102
variances are derived by comparing the actual amounts and the budgeted or Responsibility Centres
standard amounts for the period. It may be stressed that variances are the key
part of the RA system and help in materializing the idea of Management by
Exception which would be discussed in a subsequent section.

The emphasis in RA has been on controllable items. Any items which cannot
be controlled by the unit manager are normally excluded from his
performance report. However, it has to be appreciated that many items which
are not controllable at lower levels in the organization are controllable at
higher levels. Hence, they are included only in those higher level reports.
There are some items which are just not controllable within the year that is
the usual reporting period, and may be excluded from all but comprehensive
reports for the enterprise as a whole. These items might include rental on
lease agreements, insurance premiums, and other long term commitments
which remain essentially uncontrollable until the end of the year-long period,
at which time such expenses can be reviewed for future control.

Example 6.1

1. Mr. Bhaskar had to catch a flight to Dubai to attend a “Regional Finance

Conference” organized by ABC Corporation, which operates across 14
countries in the world. [Link] is the regional finance manager
handling the India region, headquartered in Mumbai. ABC Corporation
is decentralized, and each division operates independently.

On the expected date of departure, riots broke out in the city and
[Link] was unable to reach the airport. The ticket could not be
rescheduled on the same date and hence had to be canceled. The airline
does not allow return flights if the onward journey is not undertaken on
the same airline.

Although the firm has a policy of booking tickets on a refundable basis

for all foreign travel, this was a non-refundable ticket owing to the
oversight of the department in charge of booking the tickets. The loss on
account of this transaction amounted to Rs.20,000/-

Based on the information give your views on the following:

a. A Suppose the finance department had an annual budget for foreign

travel and all expenses had to be met out of that account, how will this
loss be treated?
b. Suppose the entire transaction is being handled by the Administration
Department, how will you treat this loss?
c. Suppose the transaction was handled by an in-house Travel Department,
which handled travel arrangements both inside and outside the
organization, would your answer be different?
d. What if the transaction was outsourced by the Administration
Department to an external travel agency?
103
Management Solution
Control Structure
The situation has resulted in a loss of Rs.20,000/- and the problem is to which
department this loss will be charged or who is responsible for this loss.

a. This means the finance department is responsible for all travel done by
them. This loss will be charged to the finance department, and they will
have to explain the budget variance caused by this mistake.
b. In this case, the Administration Department is responsible for the loss
and the ticket cost will be charged to finance, but the loss of Rs.20,000/-
will be charged to the Administration department.
c. In this case, Travel is a separate department and is responsible for the
loss.
d. Since the external travel agency is a different organization, the loss will
not be borne by any department of ABC Corporation. It will be borne by
the travel agency.

Example 6.2

Radio Masala is an extremely hip and happening channel and has a large
listener base, predominantly the youth. The radio channel is constantly on the
lookout for programs and product offerings for the young generation.

The organization has several popular radio jockeys who present various
programs. Each of the programs, depending on its popularity, gets
advertisement revenues. The advertisement revenues are directly traceable to
the programs and are taken off the air if they do not attract sufficient
advertisement revenues.

There are support staffs that arrange music and handle other administrative
functions like fixing an appointment with celebrities, arranging interview
schedules, etc.

Administration and payroll are being handled by a separate Establishment

Department. Training is a separate function and handles, most importantly,
training new RJs and helps them with voice training, and imparts other skill
sets required by them. Training is largely an in-house function, but lately,
there is a clear demand in the market for training aspiring radio jockeys and
the same can be offered as a 6-month course in the market.

All of the above departments have support assistants who perform most of
the errand functions.

Trace each of the mentioned above-mentioned functions to its responsibility

centre and justify your choice.

Solution

104 The various functions can be identified as follows:

Program: Programme is a revenue centre and revenues are directly traceable Responsibility Centres
to each program.
Administration and payroll: Costs are incurred but revenue is not directly
attributable to this department. So it is a cost centre or an expense centre
Training: Training is also a cost centre since costs are incurred for training.
However, since the training function can be extended beyond the
organization and revenues can be earned, the training function has the
potential to become a profit centre.
We have understood that there are different responsibility centres in an
organization. Do they perform similar functions? Should they have the same
evaluation measures? The answer to this is a clear “No”. Let us understand
the performance evaluation for various responsibility centres in the
forthcoming chapter.
Business cases

Case 1:

ABC Mills is India’s leading textile manufacturer that caters to the growing
retail cloth business. ABC Mills manufactures cotton textiles in different
colors and supplies to all retail cloth store chains which sell them under
different brands. Within a short span of 5 years since its inception in 2004,
ABC Mills has grown from strength to strength and today employs over 800
employees in their production line. The company sells around 100,000 bales
of textiles per annum.

The company is concerned that the operations, integrated as they may seem,
do not give them an idea about their strong areas or the weaknesses in their
production processes. To address this concern and also to assess
opportunities for outsourcing, as well as sourcing, they have decided to create
responsibility centres within the organization and define the goals of each of
these individually.

There are five production departments- Assembly 1, Assembly 2, which

makes textile from yarn, the dyeing section which dyes the textile to various
colors, block print section where they do block print on the fabric and the
drying line. There is a sales office that also takes care of warehousing order
processing and negotiations with various retail stores that want to stock the
products.

There is no textile industry available around the vicinity, hence there is a lot
of demand for textile manufacturers. These are demanded by both end-users
as well as producers.

The Administration Department takes care of all other functions such as

payroll, accounts, payment follow-up from retail stores, and payment
processing to suppliers.

You are required to categorize the various departments and functions as 105
Management responsibility centres.
Control Structure
Case 2

Hindustan Vyapar Limited is considering the launch of herbal products

including soaps, shampoo, and face cream. Their production processes are
completely based on traditional and indigenous knowledge and they do not
use preservatives or chemicals. Their processes do not emit harmful wastes
and they have succeeded in embracing a clean and green production process.
They are looking at creating control systems for their business.

Identify the major elements in their control system, the set of activities that
may be involved, and set out a scope for the control system to be designed.

Your report should identify the strategy, operational reports, and a

recommendation for the control system.

4.12 SUMMARY
Strategy lays down the general directions in which an organization plans to
move to attain its goals. Strategy, in a large measure, determines the
organizational structure of large business enterprise and the relative
autonomy of its units, and they both in turn influence the management control
system and its design.

For obvious reasons, the authority in an organization has to be delegated and

responsibility assigned for achievement of the objectives and goals of the
enterprise. The process of delegation of authority and assignment of
responsibility is based on some basic organizational considerations.

Responsibility Accounting system recognizes various responsibility centres

and is tailored to the organization chart so that costs are accumulated and
reported by levels of responsibility within the organization. The organization
structure is the backbone of responsibility accounting system.

Responsibility centre is an organizational unit which is headed by a

responsible manager. Responsibility centres are established to facilitate the
achievement of organizational goals. The various responsibility centres
include: cost centres, revenue centres, profit centres, and investment centres.

There are certain criteria which would determine how a responsibility centre
would be designated or called.

There are two types of cost centres: Engineered, and Discretionary (or
Managed). The distinction is important because it has substantive
implications for management control. Some special discretionary cost
centres, which present unique problems with respect to measurement of
output and performance, include: Administrative and Support centres,
R&D centres, and Marketing centres.

106 Responsibility accounting system, by calculating variances, is uses the

concept of Management by exception which focuses the attention of Responsibility Centres
management on deviations where there is a potential for improvement.

Two factors: level of management responsibility, and time span, would

determine whether a cost is controllable or not.

4.13 KEYWORDS
Cost centre: An organizational unit (responsibility centre) headed by a
responsible manager whose costs are accumulated and reported.

Controllable cost: Any cost on which the manager of a responsibility centre

can exercise control through his influence or decision.

Discretionary cost centre: A cost centre where the magnitude of costs

depends on the discretion of the top management and where costs are not
controllable at the responsibility centre level.

Engineered cost centre: A cost centre where the incurrence of costs (inputs)
in relation to outputs can be laid down on the basis of engineering
standards/estimates.

Investment centre: A responsibility centre whose manager is responsible for

both profits and a return on investment.

Management by Exception: A management and reporting system where the

attention of the manager is drawn towards significant deviations from the
norms so that s/he can focus his attention to avoid the chance of their
recurrence.

Profit centre: A responsibility centre whose manager is responsible for a

targeted profit.

Responsibility Accounting: A system of accounting and management

control which recognizes various responsibility centres and is tailored to the
organization structure and whose inputs (and outputs, depending on the
nature of responsibility centre) are measured and reported.

Responsibility centre: An organizational unit, headed by a responsible

manager, has its inputs and outputs (whether or not outputs will be measured
depends on the intent of the top management), which may either be goods or
services.

Revenue centre: A responsibility centre whose manager is responsible for an

agreed (targeted) level of revenues and for which the latter are measured and
reported.

Variance: The difference between the actual cost and the standard or
budgeted cost (i.e., deviation, either positive or negative, from the agreed
target).

107
Management
Control Structure
4.14 SELF-ASSESSMENT QUESTIONS
Questions

Multiple-choice questions
1. Management Control is different from operational control because:
i. Management Control is a function of the top management
ii. Management Control includes both short term tasks as well as long
term activities
iii. Management Control involves communication from the top
management
2. Which of the following statements describes the function of control
well?
i. Control process is not finite, does not have definitive boundaries or a
clear starting and an endpoint
ii. It involves the control of all activities by not allowing any external
influences
iii. It starts with planning and ends with action
3. Developing control systems in an organization is extremely complicated
because,
i. It involves sophisticated equipment and investment
ii. It involves an extensive human interface and cannot be completely
automated
iii. It is very expensive to implement and does not justify the cost
involved
4. The device that measures what is happening in the process is called
i. Assessor
ii. Detector
iii. Effector
5. This involves drawing a road map covering the medium to the long term
of the business
i. Strategic planning
ii. Operational Control
iii. Management Control
State whether True or False
a. Controls are not necessary because they are expensive to design and
cumbersome to maintain.
b. The element which determines the significance of what is happening by
comparing it with the expected performance or the standard performance
108 is called the assessor.
c. The output of management control is always measured by financial Responsibility Centres
measures.
d. Operational control relates to the term near-term activities of the
business.
e. Profit centre must generate profit, else it is called a cost centre.
f. Revenue centres are not responsible for the control of costs.
Theory questions
1) Examine the relationship between strategy, structure and management
control.
2) What are the reasons for delegation of authority and assignment of
responsibility?
3) Explain the concept of Responsibility Accounting and describe its
benefits. What purpose does it serve?
4) What is a Responsibility Centre and why are responsibility centres
established? Briefly explain each type of responsibility centre.
5) What criteria would determine the designation of a responsibility centre?
6) What is a Variance? How would you determine the significance of a
variance?

4.15 REFERENCES
Andrews, Kenneth R., 1971, The Concept of Corporate Strategy,
Homewood, Illinois:
Anthony, Robert N. and Reece, James S., 1975, Management Accounting.
Text and Cases, Irwin: 680.
Anthony, R. [Link] Govindrajan, V., 1998. Management Control Systems,
Tata McGraw-Hill: 129-148.
Bhatia, M. L., Role of Central Management in Decentralized Structures,
Management
Review, 1, 1982: 1-5.
Gray, J. and Johnston, K.S., 1977, Accounting and Management Action, (2nd
ed.), Tata McGraw-Hill: 517-19.
Horngren, C. T., 1993, Cost Accounting. A Managerial Emphasis,
Englewood Cliffs, N.J.: Prentice-Hall.

4.16 FURTHER READINGS

Anthony and Govindarajan, Management Control Systems, 12th Edition, Tata
McGraw Hill
D. Shields, 785-804, Amsterdam: Elsevier Press.
Daniel W. Lang(1999), Responsibility Centre Budgeting and Responsibility
Centre Management in Theory and Practice, Higher Education Management
109
Management Vol. 11, No. 381 OECD.
Control Structure
Handbook of Management Accounting Research. (Ed.) C. S. Chapman, A. G.
Hopwood, and M.
Hanzlick and Bruhl, Management control systems as a package, CIMA
Journal, Volume 13, Issue 2, April 2013
Lynch, Richard M. and Williamson, R. W., (Latest edition), Accounting for
Management: Planning and Control, Tata McGraw-Hill, New Delhi.
Nilsson, Göran., Anthony, Robert., Hartmann, Frank., Kraus, Kalle., Govindarajan,
Vijay. EBOOK: Management Control Systems, 2e. Spain: McGraw-Hill
Education, 2020.
Marciariello, J.A. and Kirby, C.J., 1994, Management Control System(2nd
ed.) Prentice Hall of India.
Maciariello and Kirby, Management Control Systems- Using Adaptive
Systems to Attain Control, 2nd Edition, Prentice Hall India, pp-1
Merchant, K. A., & Otley, D. T. (2007). A review of the literature on control
and accountability.
Otley D, Broadbent J, Berry A. Research in Management Control: An
Overview of its Development. British Journal Of Management [serial
online]. 1995;(SPEISS):31. Available from: General One File, Ipswich, MA
Van der Stede, W. A., Merchant, K. A. (2017). Management Control Systems:
Performance Measurement, Evaluation and Incentives. United Kingdom: Pearson.

110
UNIT 5 COST CENTRES Cost Centres

Objectives

• Understand the concept of cost centres

• Appreciate the relationship of cost centres with other responsibility
centres
• Understand the difference between standard and discretionary cost
centres
• Understand the concept of zero base budgeting and Activity based
costing
• Find out which costs are controllable and which ones are uncontrollable.

Structure

5.1 Introduction
5.2 Type of Cost Centres
5.3 Measuring the Performance of Engineered Cost/Expense Centres
5.4 Performance Evaluation of Discretionarily Cost/Expense Centre
5.5 Balanced Score Card
5.6 Activity Based Costing
5.7 Some Special Discretionarily Cost Centres
5.8 Controllability vs. Non-Controllability of Costs
5.9 Summary
5.10 Key Words
5.11 Self Assessment Questions
5.12 Further Readings

5.1 INTRODUCTION
We understood the type of responsibility centres in the previous chapter. We
will now understand how the performance of various responsibility centres is
evaluated. We will understand that not every responsibility centre can be
evaluated using similar measures because the function performed by each of
them is different.

A responsibility centre wherein the manager is responsible for cost control

can be termed as a Cost Centre or an Expense Centre. There are two types of
cost centres which are given below:

• Engineered expense centres or Standard Cost Centres

• Discretionary expense centres.

111
Management Generally, in Engineered costs, standards can be set because the input is
Control Structure
usually relatable to the output. Based on these standards or benchmarking
they can be termed Standard costs.

Input related to output

Input Output
WORK

Figure 5.1: Engineered Expense Centres

5.2 TYPES OF COST CENTRES

For better understanding, let us precede the discussion about the two types of
cost centres with an explanation on the relation between inputs and outputs
and some other aspects.

Relation between inputs and outputs: The goal of management is to obtain

the optimum relationship between inputs and outputs. In some situations, the
relationship is causal and direct, for example, in the production department.
But in many situations, it is not so. Advertising expense is an input which is
expected to increase sales revenue; but the latter is affected by many factors
other than advertising. Basically, how much money should be spent on
advertising is a matter of judgment. For R&D, the relationship is even
more ambiguous. The value of R&D’s efforts may not be known for several
years, and the optimum amount that a company should spend for R&D is
indeterminable, and again depends on Management’s judgment.

Measuring inputs and outputs: The resources consumed in an RC are

translated into monetary terms, as the latter provides the common
denominator. The resources used multiplied by the price per unit paid is
called “cost” which is the monetary measure of the amount of resources used
by an RC. Please note that inputs are the resources used. The patients in a
hospital or the students in a school are not inputs; inputs are the resources
used in treating the patients and educating the students. Treatment of the
patients and education of students are objectives of the two organizations
respectively. While inputs are easier to measure, it is not so in the case of
outputs. In a profit-oriented organization, revenue is an important measure of
output of the whole organization. However, the revenue of a period may not
truly reflect all the efforts made in that year. For example, the value
of the money spent on R&D, employee training, or advertising and sales
promotion carried out in a particular year may not be fully realized in that
year, but also in the subsequent years. Besides, outputs in many RCs cannot
be measured satisfactorily, e.g., public relations department, quality control
department, or legal department. In many non-profit organizations, a
satisfactory measure of output may not exist. For a college, it is not
difficult to measure how many students graduated; but how many got
education in the real sense of the term is difficult to measure. It may,
112 therefore, be not worthwhile to measure outputs of such RCs, unless one is
ready to use surrogates, or approximations (which are indirect measure of Cost Centres
output).

Efficiency and effectiveness: The RCs may be judged in terms of the criteria
of efficiency and effectiveness, which are used in comparative rather than
absolute sense. Efficiency is the ratio of outputs to inputs. Organizational unit
A is supposed to be more efficient than another unit B if (i) it uses lesser
resources than unit B, but has the same output; or (ii) it uses the same amount
of resources as unit B, but has greater output than unit B. In many RCs, a
measure of efficiency can be developed that relates actual costs to some
standard, that is, what costs should be incurred for the amount of measured
output which can be a useful indication of efficiency.

Effectiveness is the relationship between an RC’s outputs and its objectives.

The more these outputs contribute to the objectives the more effective the
unit is. Since both objectives and outputs in some cases are difficult to
quantify, measures of effectiveness are difficult to evolve. Effectiveness,
therefore, is often expressed in non-quantitative, judgmental terms, e.g.,
hospital A is doing a better job than hospital B.

An organization should be both efficient and effective; it is not a matter of

choice, either one or the other. To sum up, it may be said that an “RC is
efficient if it does things right, and it is effective if it does right things.”

The different types of cost centres in an organization are listed below:

Personal cost centre – Some cost centres are maintained for a particular
person or a group of persons to capture the cost and monitor, such as the
Finance Manager, HR manager etc.

Impersonal Cost centre – Here it deals with other than persons such as
equipment, machinery, or locations. Example South India Sales Region,
Research & Development unit etc.

Production cost centre – Departments or units which directly relate to

production are classified thus. Example Tools department, Grinding unit of
Production line, etc.

Service Cost centre – The support services to the main business line are
termed as a service cost centre. For example, the procurement department,
finance department etc. These service centres also provide service to the
whole organization or rather to all the departments in the organization.

Operation cost centre –This cost relates to either person or machinery

captured in a particular unit. For example, operational costs in an IT
organization include the salary of people in that account and the cost of
laptops for the team members.

Process Cost centre – This cost is captured for a particular process in an

industry. For example, the cost of making rolling the steel in the rolling mills
is the process cost of rolling wire rods.
113
Management Earlier we had mentioned that there are two types of cost centres:
Control Structure
Engineered cost centres, and Managed or Discretionary cost centres. Let us
explain what they mean.

Engineered cost centres

An engineered cost is defined as one where there is a close causal (physical)

relationship between the quantity of output and the amount of cost or expense
(the input) and, hence, the “right” or “proper” amount of costs that should be
incurred can be estimated with a reasonable degree of reliability. It is fairly
easy to estimate the input-output relationship by engineering means. The raw
material (an input) required to produce a part (output) is a good example.
Once the production method is decided, the engineers are able to estimate
the quantity of raw material required to produce one unit of product by the
prescribed method by analyzing the nature of the production process or by
test runs. Any significant variations in the amount of raw material used per
unit of output are not expected unless there are inefficiencies, changes in
production methods, or changes in the quality of materials or labour used.
Some other examples are: components, supplies, and utilities.

For cost (or expense) centres, a system of standard costing is required for
reporting variances. The two categories of raw materials and labour are
usually found to be variable items and they are usually very significant in
amount. A standard cost system is most appropriate. Since standard costing
system is a prerequisite for an engineered cost centre, the latter is also known
as a “standard cost centre.” Performance in standard cost centres is measured
primarily on the basis of efficiency and quality. The difference between
standard and the actual cost represents the efficiency of the cost centre.
Sometimes, cost minimization may occur at the cost of quality and volume
which produces a dyfunctionality (which arises from a lack of goal
congruence, i.e., the goals of the individual managers do not match with the
goals of the organization leading to sub-optimal results). To minimize
this tendency, it will be desirable to prescribe the type and amount of
production expected as well as quality standards required. Apart from quality
(which would indicate the effectiveness of the RC), managers of engineered
cost centres are also often made responsible for activities such as training,
which is not related to current production.

Therefore, in appraising performance such factors should be taken into

account.

In short, engineered cost centres have the following characteristics:

• Their inputs can be measured in monetary terms.

• Their outputs can be measured in physical terms.
• The optimal amounts of inputs required to produce one unit of output can
be established.

114
What is important to note is that in engineered cost centres, the tasks are Cost Centres

repetitive and mostly routine and hence standard costs can be developed. It
must be said, as we shall elaborate later, even managed costs centres may
have one or a few engineered cost centres, e.g., cafeteria under HRM
department, shareholders records in the corporate secretarial department, and
distribution and trucking within the marketing department. Another thing to
note is that there may be very few RCs in which all costs are engineered
costs. In these days of high automation, the change in management thinking
or a change in the policy in relation to a so-called engineered cost centre may
alter the character of costs. Hence, it will be more befitting to say that
engineered cost centres refer to those RCs where engineered costs
predominate; and it does not mean that valid engineering estimates can be
developed for each and every cost item.

Managed cost centres

Discretionary cost is a capital expenditure that can be avoided in the near

term without having an impact on the short term profit of the organization.
Advertising, building, and machinery are some examples of discretionary
costs.

In a discretionary expense centre, there are predetermined costs that have

been set as goals with mutual agreement between management and the
department. Budgetary performance is evaluated by comparing the actual
cost with such budgeted/predetermined costs set as goals. The discretionary
expense can be explained with the help of the following two important
features.

• Based on yearly review they arrive at the maximum outlay to be incurred

for a particular activity. These costs can generally be controlled or
reduced and need not be essential costs.
• They are not tied to a clear cause and effect relationship between inputs
and outputs

We can think of several examples to illustrate a discretionary expense centre.

For ABCD Corporation, the design department could be a discretionary
expense centre. This is because depending upon the number of new designs
or requirements for designs the output of this division may vary. There is no
specific input-output ratio. There could be several other examples for the
Discretionary expense centre. The marketing department could be another
example. There are expenses incurred for marketing but there is no defined
output that is relatable to the expenses incurred.

Because of the nature of Discretionary Expense centres, it is difficult to

evaluate the performance of these responsibility centres.

115
Management
Control Structure
Activity 1
Can you think of some examples of discretionary expenses?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

On the other hand, a Discretionary cost (or Managed cost, or committed cost)
is one in which only a weak causal relationship is observable between the
volume of output and the amount of managed cost (or where an engineered
estimate is not feasible). If, in fact, absolutely no causal relationship exists
between the amount of cost incurred and the specified output, one could
question whether management is justified in spending anything on account of
such cost or expense. But usually and in most of the cases the causal
relationship is apparently week because output of the process occurs much
later than the input. For example, many of the indirect expenses are basically
discretionary in character, firstly, because how much amount is to be spent
depends on the discretion and judgment of the management based on an
assessment of the situation; and second, the output (or outcome) of the
expense incurred would be known only later (or much later).

The delay between incurrence of input and happening of output creates

considerable uncertainty about how much of the output was caused by the
input (expense) and how much was caused by other factors. There is, so to
say, no direct relationship between input and output, unlike the case with
engineered costs. Therefore, discretionary cost centre designation is
appropriate for units in which the outputs cannot be related precisely
to organizational goals. For example, what and how much do administrative
and support units, e.g., public relations, personnel, accounting, human
resources and legal departments contribute to profit which is often one of the
dominant goals of business? Because the contribution is quite indirect, it is
difficult to establish appropriate input levels in any scientific manner. Costs
are quantifiable, but contributions or outputs are not. Discretionary cost
centres, in fact, are overhead responsibility centres. The magnitude of the
expense on account of such items, as we stated earlier, depends on the
judgment or discretion of the top management which in turn is influenced by
industry procedure and situation; hence, the phrase discretionary costs. Percy
Bamevik, CEO of Asia Brown Boveri, was known for slashing corporate
staff after completing major acquisitions. For instance, the staff in
his U.S. subsidiary was reduced from 600 people to 100 over 2 years; staff in
his German subsidiary was reduced from 1600 people to 100 in 3 years.

116 Since such costs are not controllable at the levels they are incurred, they are
shown separately in the responsibility reports, and where full costing is used, Cost Centres

these costs are traced to products through overhead allocation. Some

discretionary costs appear as period expenses (for example, selling, general
and administrative expenses) in the summary financial statements like Profit
& Loss Account at the end of the year.

Two other prominent examples of managed cost often cited are:

(i) basic research expense; and

(ii) advertising expected to develop the recognition of the company name

(as opposed to advertising directed at increasing sales of a
particular product).

Though it might seem wise to spend money on these types of activities,

the problem is in deciding how much. Two companies of the same size in
the same industry may have quite different size of
corporate communication staff. The managements of both companies may
have valid reasons for the correctness of their decisions, but here theme is
no objective way of judging which decision is the correct one. In the
same company dramatic changes may occur when a new management
takes over.

In the case of raw materials, it can be easily calculated as to how much

raw material would/should be used for producing a certain quantity of
output (say 1000 units), but it is not so in the case of managed items.
Compared to engineered cost centres, the chances of dysfunctionality are
more in discretionary cost centres, particularly in some types of
discretionary cost centres like R&D and legal departments because
professional staff members have professional goals that may sometimes
conflict with the goals of the organization. Professional self-interest, and
not organizational goals, may sometimes direct their behaviour. The staff
may want to develop the ideal system and procedures, but the ideal,
however ,is often more costly than the optimum so far as the organization
is concerned. It is, therefore, necessary to keep a regular and careful
watch on the expenses of such discretionary cost centres.

In a discretionary cost centre, 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. If actual expenses do not exceed the
budget amount, the most we can say is that the manager has “lived within his
budget.” We cannot say that living within the budget is efficient performance.

It should be appreciated that engineered costs and managed costs are terms
used to describe points on a, more or less, continuous scale, as illustrated in
Figure 5.2 which points out that most costs fall somewhere in between purely
engineered costs and purely managed costs. Product design cost is on the
managed side, but closer to engineered cost than “advertising cost to improve
the company image. Maintenance of production equipment probably lies
117
Management toward the engineered cost side. Usually management could estimate how
Control Structure
much additional maintenance cost would be required if production output
were increased by, say, 10 percent. But even so, the physical link between
maintenance expense and output is not nearly as close as the relationship
between raw material use and output.

Engineered Managed
Cost Cost

Raw Maintenance Product design Advertising

material expense expense company image

More certain Less certain

output-cost output-cost
relationship relationship

Figure 5.2: Cost Continuum - Engineered and Managed Costs

The distinction between engineered and managed cost has an important

implication for developing an appropriate control and reporting method.
Hence, the first step in designing a responsible reporting system for any cost
centre is to examine each cost (or expense) whether or not it is controllable
by the unit manager and classify it as being primarily engineered or primarily
managed. The reporting system then can be adapted to match the type of cost
being considered. A reporting system for engineered costs tends to be highly
quantified and formal, whereas a system for managed costs is normally less
quantitative and more informal. For the expenses/costs near the middle of the
continuum depicted in Figure 5.2, some sort of hybrid reporting system may
be appropriate. There are two pertinent points in relation to designing of a
reporting system for a cost centre:

1) In measuring the financial performance of a cost centre manager, a report

which eliminates the impact of changes beyond the control of the
manager is desirable.
2) Cost variations resulting from volume fluctuations which are beyond the
control of the cost centre manager should be eliminated by the reporting
system in measuring the financial performance of the manager. Standard
cost systems and flexible budgets, the main tools for control of
engineered costs, are designed to automatically allow for volume
fluctuations.

In regard to discretionary cost centres, there are some general considerations

which need to be kept in view in designing the control system.

118
5.3 MEASURING THE PERFORMANCE OF Cost Centres

ENGINEERED EXPENSE CENTRES/

STANDARD COST CENTRES
“Standard costs” are costs that are predetermined by the management based
on experience, that we incur these costs for this level of production or output.
They are set as targets to be met and, after the activity is carried out, the
actual cost incurred is compared with this target. They are the predetermined
cost based on the estimates for materials, labour and overheads for a
particular period. One of the most important uses of standard costing is to
compare the actual costs with the standard costs and analyze the reasons for
the variations with the view of maximizing the efficiency of production.
Variation is the difference between standard cost and actual cost.

Variance analysis is the actual comparison of actual costs incurred with

standard costs and flexible budgets and is a typical cost control tool in a
production department.

General Model for Variance Analysis

Two general types of variances can be calculated for most cost items-
a. Price variance
b. Quantity variance.
[a]Price Variance is calculated as:
Price variance =Actual quantity x [Actual price - Standard price] (1)
Price variance = AQ × (AP – SP)
Price variance = (AQ × AP) – (AQ × SP) (2)
[b]Quantity Variance is calculated as:
Quantity Variance = Standard Price per unit × (Actual Quantity used –
Standard Quantity)
Quantity Variance = SP × (AQ – SQ)
Quantity Variance = (SP × AQ) – (SP × SQ)

Example 5.1

Calculate material cost variance from the information given below:

Particulars Units(kg)
Actual Price Rs. 8 per kg.
Standard output 1,500 units
Standard quantity for standard output 1,500 kg
Actual output 1,200 units
Actual Quantity used 1,320 kg
Standard Price Rs.7.00 per kg

119
Management Solution:
Control Structure
The following table gives the details
Details Standard Actual
Output 1500 units 1200 units
Material Quantity 1500 Kg 1320 Kg
Material Quantity for 1 unit of 1 Kg
output) to be used
Standard Quantity (for actual 1x1200 = 1200 Kg
output) to be used
Price Rs 7 per Kg Rs 8 per Kg
Standard Price for Standard Quantity 7x1200=8400
Actual Price for Standard Quantity
Actual Price for Actual Quantity 8x1320 = 10560
Material Cost Variance 10560-8400 = 2160
Material Price Variance 1320 (8-7) = 1320
Actual Quantity ( Standard rate -
Actual Rar=te)
Material Usage Variance 7 ( 1200 - 1320) = 840
Standard Rate (standard quantity -
Actual quantity)
The variance of Material cost =
Actual cost –Standard cost or
Standard Quantity x Standard Rate - Actual quantity x Actual Rate
MCV = (SQ × SR) – (AQ × AR)
= (1,200 × 7) – (1,320 × 8.00) = 8400 – 10560
= 2140 (U)

The calculation is for actual production and not for planned production.

So here the Material Cost Variance is Rs.2140

The variance of Material Price = Actual Quantity used× (Standard Rate-
Actual Rate)
=1320× (7-8)
=1320(U)
The variance of Material usage = (Standard Quantity-Actual Quantity) ×
Standard Rate
= (1320-1200)×7
=840 (U)

The variance of Material cost=Material price Variance +sum of Material

quantity (usage) variance

Similarly, variances can be calculated for wages and overheads and these
variances are analysed to evaluate the performance of a Standard Cost
Centre.

120
It is important to make four observations: Cost Centres

1. For the three variable cost items, a quantity variance and price variance
can be calculated— direct materials, variable portion factory overhead
and direct labour. The name of the variance for direct materials is called
materials price variance, for factory overhead it is called variable
overhead spending variance and for direct labour, it is labour rate
variance.

2. If the standard price (SP) or standard quantity SQ is exceeded by actual

price (AP) or actual quantity (AQ) then the cost variance is
“unfavourable (U). If the standard price or standard quantity is more than
the actual price or actual quantity, a variance is favourable (F)”.

3. The key concept in the analysis of variance lies in the standard quantity
allowed for output—item (3). The standard quantity should have been
employed to achieve actual output. It is calculated by multiplying the
number of input units permitted by the actual output.

4. Variances for fixed overhead are of dubious utility for control purposes
because they are frequently outside the control of the production
department.

5.4 PERFORMANCE EVALUATION OF

DISCRETIONARY EXPENSE /COST CENTRE
In regard to discretionary cost centre there are some general considerations
which need to be kept in view in designing the control systems.

Discretionary cost centre mainly relates to the non-essential costs that can be
controlled by a Manager. For example, the travel and hotel costs incurred by
the sales team to sell the products or services. If the Sales team manager is
not vigilant these costs will be huge compared to the order they have bagged.
Hence in such situations, there are budgets set aside for these costs and are
closely monitored periodically (say monthly) to ensure that the costs do not
exceed the budget.

Budget preparation: While the budget in regard to engineered cost centres

depends upon the task to be performed (which in turn depends on the other
RCs), the budget for a discretionary cost centre depends upon the magnitude
of the job that the management wants it to perform. In addition to the
continuing tasks, the management may assign a discretionary cost centre one
or more special tasks during a budget period. In preparing the budget for such
a centre, a technique called MBO (Management by Objectives) can
be highly useful in appraising its performance.

Further, unlike engineered cost centres where costs vary with short-run
changes in volume, costs in discretionary cost centres generally increase in
steps, rather than in a linear fashion. If the volume is expected to increase in
121
Management the next period beyond a certain limit or range, an additional budget is
Control Structure
provided, which may be a certain percentage of the volume. In view of
absence of direct variability, a flexible budget for such costs is more suitable
for increased or decreased volume of activity. Thus, although the costs of
discretionary cost centres are sometimes classified as fixed, they are in fact
fixed only over a year or so or over a certain volume, and tend to change with
changes in volume from one year to the next. The absence of direct
variability also has another implication. The control on discretionary costs
has to be exercised at the beginning, i.e., at the planning stage before the
amounts are incurred.

In every organization, a budget is prepared every year, based on the past

year’s experience for a specific volume of output. The management further
modifies it depending on the activity level forecasted for the current year,
cost escalations, process modifications etc. The work done here falls into two
general categories:

Continuing work- This is the regular core business activity carried out by
the organization, and does not involve much change compared to the
previous year. For example production activities in a manufacturing
organization, preparation of financial statements etc.

Special work indicates non-regular activities which are different from the
core business of an organization. They are usually one-time projects or
assignments, such as building and deploying a system inside a newly
acquired section.

Management By Objectives (MBO) is the formal process wherein the

management plans their activities/goals for the current financial year with the
help of a budgeting tool. MBO is a formal process in which a department
proposes to accomplish specific jobs along with the cost, material and time
estimates required to complete the said activity. These goals are termed
budgeted variables or estimates which serve as a benchmark to compare with
actuals on completion of the activity. The budget is also viewed as a planning
tool to achieve the organization’s goals.

The planning function for the discretionary expense centre, however, has a
slightly different budgeting tool - Incremental budgeting and Zero-base
review

1. Incremental budgeting
In this model, there needs to be a starting point or base from where the
budget is planned. Usually, the discretionary expense centre lists down
the current expenses which serve as the baseline. This amount is adjusted
for inflation, anticipated changes in the workload of continuing jobs,
special job requirements and the cost of comparable jobs in similar units.
This model has two drawbacks:

122
• Firstly, the centre’s current level of expenditure is taken as the base or Cost Centres

benchmark without examining for any possible reduction in expenses.

• There are no provisions or adjustments incorporated for an increase in
activity levels. So any change or increase in activities will create a
shortfall in the budget.
Despite these limitations, most organizations follow incremental
budgeting for their discretionary expense centres.
2. Zero base review
In this method, a thorough analysis is done of each discretionary expense
centre on a rolling schedule so that all are reviewed at least once every
five years. This is called zero zero-base-view, wherein there is no base or
the base is taken as zero. In contrast with incremental budgeting, this
method considers each activity as a new one (irrespective of whether it
has been carried out before this) and lists down all the estimates to
complete the activity within a specific period.

Zero-base budgeting:

For discretionary cost centres, a budgetary approach called Zerobase

Budgeting is more appropriate than the generally used approach of
incremental budgeting. Rather than taking previous year’s budget as the
starting point and adjusting that amount for inflation, etc., as is done in
incremental budgeting, every expense under zero-base budgeting is put to
close scrutiny and is questioned whether it is needed at all
(can we dispense with it; is the function for which the money is beingspend
needed at all; and, if needed, how much of it is needed, etc.? The responsible
managers are supposed to have a fresh look at it. That is, you start from zero
(as the base) and not the budget of the previous year. In this process, the
technique of benchmarking (i.e., how much other comparable or model
companies are spending, or what is the industry average may be relevant
questions to ask?).

Zero-base reviews, however, are time-consuming and may not be well taken
by the managers whose budgets are being reviewed in zero-base fashion.
Hence, such reviews may be taken up once in 3-5 years, rather than every
year.

Budgeting on a zero-base basis forces expenditure plans to compete for

financing on an equal footing — starting from zero. Every department in the
organization puts up the budget proposal based on the activities proposed to
be undertaken in the current year. Approvals are required for these expenses
and the departments have to give the required justification when they put up
the budgets for approval. When determining spending or budgetary levels for
the coming year, prior year expenses or costs are not taken into account. Each
expense category begins with a zero value. All budget spending or cost levels
must be justified or re-justified as necessary; hence, "zero-base."
123
Management Application of Zero-base budgeting in business
Control Structure
The practical application of ZBB involves the use of the “Decision Package”.
The organization’s objectives form the basis of activities that are to be carried
out in the current year. For activities that make it difficult to compare the
resources allocation with output, there is no benchmark or base level of
resources that can be a referral for budgeting (the current activities). If
previous projects are permitted to continue without explanation, previous
inefficiencies will be perpetuated. As a result, the manager must defend why
he wants to keep spending. For such projects/activities, ZBB is an appropriate
process or control mechanism.

Advantages of ZBB:

• To help justify expenses throughout each budget cycle, zero-based

budgeting is used. The justification given for the budget proposal ensures
that only those projects which are efficient/viable get funded thereby
reducing losses.
• It also aids in the prevention of waste, fraud, and abuse in the system.
Because the budget begins at zero so each expenditure is accounted for.
• Zero Based Budgeting ensures optimum allocation of resources which
results in increasing the efficiency of the project.
• It is especially useful for service departments where it is extremely
difficult to quantify or identify the output.

5.5 BALANCED SCORE CARD (BSC)

The Balanced Scorecard (BSC) was created by Kaplan and Norton in the
early 1990s. It's a method for translating a company's vision into a set of
performance metrics that span four crucial perspectives: internal business
processes, financial, customer, learning and growth.
By balancing the quantitative (financial) perspectives with the qualitative
(customer, business process and learning and growth) perspectives, BSC
makes it easy to evaluate the outcome of processes with a focus on quality.
Output measurement in non-quantitative terms is made easier using the
Balance Score Card.
The Balanced Scorecard is a performance measuring tool that employs a
strategy map to link an organization's day-to-day operations to its overall
objectives. It is concerned with developing a strategy to guide future
direction, incorporating cause and effect relationships while also considering
both financial and intangible resources that might decide success or failure.
The Balanced Score Card, while retaining traditional financial measures,
focuses on creating future value by investing in customers, suppliers,
employees, processes, technology, and innovation. The balanced scorecard
suggests looking at the organisation from four different angles and
124 developing metrics, collecting data, and analysing it from each of these points
of view: Cost Centres

• Financial perspective: This refers to determining an organization's

financial goals. It is critical for BSC since financial objectives represent
an organization's long-term aspirations.
• Customer perspective: This refers to defining the customers and market
sectors with which they will compete, as these are the foundations for
achieving revenue components of the company's financial goals. It is
primarily concerned with achieving high levels of customer satisfaction
and maximising customer connections.
• Internal process perspective: This refers to identifying important
business processes that a firm must excel in to satisfy the goals of its
consumers and shareholders.
• Learning and innovation perspective: This refers to identifying and
achieving ambitious goals in the other three viewpoints. It emphasises
the ability to adapt and improve to achieve long-term corporate
objectives.
Concept in Action- Nerolac Paints and Infosys
Nerolac Paints Limited: For launching its business strategy and managing
enterprise performance, the company chose the BSC approach. The BSC is
being implemented in the Company to increase business profitability over the
next few years. The scorecard framework is designed for Nerolac's decorative
and industrial paints industry, and it creates a strategy deployment
mechanism that will track month-to-month progress against set strategic
goals.
Infosys Technologies: Infosys is another company that has adopted the BSC
model. It assists this organisation in tracking its initiatives as well as
determining their impact on the company's growth and profitability. It also
helps Infosys transition to a data-driven decision-making culture.

Each responsibility centre has different evaluation measures, which are

summarised as follows:

Responsibility Responsible for Evaluation measure

Centre
Standard Cost Cost control, Efficiency, Variance Analysis-
Centre Quality of Output, Comparison of Actual with
Timeliness Standard
Discretionary Quality of Output Qualitative output measures,
Expense Centre Compliance with pre-
approved budget spending
limits

Measurement of performance: While spending less than the budget in all

likelihood will be an indication of the efficiency of an engineered cost centre,
it may often not be so in the case of discretionary cost centre. If spending
125
Management more than the budget is a matter of concern, spending less is also a matter of
Control Structure
concern. It is fallacious to regard the money saved as a measure of efficiency;
it may rather indicate that the planned work has not being achieved. As a
discretionary cost centre is expected to do a job, the same cannot be
achieved if the budgeted amount is not spent (otherwise that amount would
not have been budgeted).

Difficulties in evaluating Discretionary Expense Centre

Discretionary cost is always difficult to control or monitor as it is not directly

linked to the output, for example, R & D costs. For the same reason,
organizations find it difficult to evaluate the performance of a discretionary
manager. Though organizations have tried their best to co-relate the
discretionary expense the activity levels, they have not been successful in
arriving at a logical conclusion or relationship between the two. Discretionary
costs remain purely a management discretion or judgement because of this.
Hence, generally, the management gives a budget to the discretionary cost
centre managers and instructs them not to exceed it without a higher level of
authorization.
The term discretionary means that the company's management decided on
specific policies that should control the company's operations. Therefore, no
relationship is established between the input and output generated as far as
the discretionary expense is concerned.

Some of the salient features of Discretionary Expense Centres are listed

below:

1. Staff units which include departments of general and administrative such

as R & D departments, legal, finance, HR and marketing units which
performs promotion and advertising, are generally treated as
discretionary expense centre.
2. It is difficult to construct cost control measures for some functions where
the output is not measured easily or when there is no solid relationship
between the input and output units. Various cost control techniques such
as standard costs also prove to be insufficient in such centres.
3. These functions are generally organized as discretionary expense centres
wherein the number of personnel level and the level of expenditure are
determined by negotiation with central management to determine the
levels of quality and service which are appropriate.
4. The output from these units is not easily measured in financial terms, and
the input (of resources) and output (products/service) relationship is
weak.
5. Companies control these discretionary expense centres by negotiating
and eventually authorizing an annual budget mutually agreed upon.
Subsequently, their actual spending is monitored to make sure it remains
within the budgeted amounts.
126
Since output measurement is difficult, the performance evaluation of a Cost Centres

Discretionary Expense centre could pose several difficulties which are as

follows:

1. First, the management control system helps only in expense control. The
budget for this type of expense centre gives an upper limit of the
inputs/expenses that have been agreed upon.

2. Second, the difference between budgeted and actual expense is not a

measure of efficiency. It is just a mathematical difference between the
budget versus the actual inputs alone.

3. Third, the financial control system measures neither the effectiveness nor
the efficiency of these responsibility centres. Hence, nonfinancial
measures and judgments can be employed in their performance
evaluation.

Several techniques have evolved in the past few decades to evaluate

performance when there is a problem with output measurement or when there
are no quantitative output measures. Some such techniques are Zero Based
Budgeting, Balanced Score Card and Activity Based Costing. A brief
understanding of these concepts follows.

5.6 ACTIVITY-BASED COSTING

During the 1970s and 1980s, activity-based costing (ABC) techniques were
developed in the manufacturing sector of the United States. The complete
process is broken down into small activities and the cost of performing each
activity is calculated. Total cost is arrived at as a summation of this
individual activity cost. Here the cost is not product related, but process-
related. As a result, determining activities is a natural first step in creating an
activity-based costing system. A single event, action, or unit of labour that
contributes to the end outcome is referred to as an activity. Some examples
include designing things, erecting machinery, operating machines, and
distributing goods.

Cooper and Kaplan defined ABC as a method for addressing the issues with
standard cost management systems. Traditional costing systems are unable to
effectively capture the cost of items and related services. As a result,
managers were making judgments based on inaccurate data, particularly
when there were multiple commodities involved.

In his book Management Challenges of the Twenty-First Century, Peter F.

Drucker defines ABC as "cost accounting that focuses heavily on what it
costs to perform something, such as cut a screw thread, while also recording
the cost of not executing a required activity, such as waiting for a needed
part." Activity-based costing assists in the recording of costs that are not
captured by traditional cost accounting. An activity cost pool is made up of
the overhead costs assigned to each activity.
127
Management ABC (Activity-Based Costing) is a performance-monitoring method that is
Control Structure
used to identify, allocate costs to, describe and report on agency operations.
By determining the "actual" cost of a product or service, ABC identifies
possibilities to improve business process effectiveness and efficiency.
Activity-Based Costing (ABC) is a cost estimation method that divides a
project into discrete, quantifiable activities or work units. Based on the
actions conducted to manufacture each product or service, ABC systems
calculate the costs of particular activities and allocate costs to cost objects
such as products and services. It accurately identifies profit and loss sources.

Activity-based Costing

Traditionally activity-based costing is calculated based on assigning the

material costs incurred and cost of direct labour to the product. But with the
latest development in technologies, companies have a limited need for labour.
For example, in the 1990s mobile handset assembling are done manually but
now this has been replaced with robotic arms in many companies making
direct labour costs redundant. As discussed, the markups on the direct labour
and material costs are assigned to the product.

Then the calculation of activity-based costing is made entirely on the process

of production. In other words, in each process, actual activity in producing
the number of volumes is considered.

Drivers of Activity-Based Costing:

• Volume – Measured by No. of Units

• Expenses related to Non-Volume

Calculation of activity-based costing is dependent on the type of production

process and the drivers considered by the management. For example, a
chipset manufacturing company could have production process drivers such
as the number of transistors to be placed, time taken for testing, soldering etc.
All these are drivers which are assigned under production cost.

An activity-based costing model takes the expenses of the factory and splits
them as:

• Cost of material Acquisition

• Cost of production
• Cost of Support

Cost of Material Acquisition:

Generally, the cost of material acquisition involves the percentage markup of

total material costs. However, calculating expenses based on the number of
receipts and purchase orders aids in determining a standard cost per piece or
commodity. This depicts the commodities that are ordered in high volumes
and commodities that are ordered in low volumes hence acquisition costs are
128 assigned based on the volume. Freight costs are also considered in the
calculation of material acquisition costs. Cost Centres

Cost of Production:

The costs which are incurred to manufacture the product after raw material
purchases are called production costs. In the production cost, cost pools are
made under each section. Employee costs are directly dedicated to each cost
pool they belong to. Along with the direct contribution of employees under
each cost pool, there is an indirect manufacturing department that contributes
to the cost pool. For example, teams of quality management, supply line, and
training teams support these cost pools. Hence the standard cost of each cost
pool is calculated using expenses budgeted and the quantity of activity in the
cost pool.

Cost of support:

Support costs are indirect costs that impact the activities of production.
Planners that plan to manufacture the product, vendors who helped in
manufacturing, the number of units audited etc. are support costs which are
significantly associated with production costs.

Advantages of ABC:

ABC helps to trace and track the actual quantity of activity either direct or
indirectly associated with the cost of the product. With the cost pools, ABC
considers even the minor contribution to the cost of production. The
development of this method helps to assess the costs without direct labour.

Advantages of Activity Based Costing

ABC is applicable throughout company financing, costing and accounting:

• ABC can be applied to calculate the total cost as well as for the partial
process.
• ABC helps to identify in efficient products, departments and activities.
• As each activity is evaluated, it helps to identify profitable products and
reallocate the resources from loss-making units to more profitable
products.
• Cost capturing and controls can be achieved at the minutest level, of say
a part of a product and can be rolled up to a department.
• ABC helps in eliminating or minimising unwanted costs.
• ABC can assist in determining the pricing of a product or service using
any analytical resolution.

ABC is an excellent tool for tracking repeated actions in HR and IT (such as

employee performance, employee training and counselling ) (providing
storage capacity, connect time, and CPU capacity). The ABC allows
corporate support departments such as HR, Legal, Finance, and others to
charge their resource costs to operating units, resulting in the overall cost of a 129
Management product. This is a unique way of cost capturing, as the traditional system so
Control Structure
far has only achieved allocating the marketing and sales cost by standard
costing method.

In effect, ABC transforms discretionary expense centres into cost centres

with a financial goal of breaking even—recovering the expenses through
cost-recovery systems of pricing based on the real demands made on the
support units' resources by operating units.

Example 5.2

To distribute overheads, XYZ Company is contemplating activity-based

costing. For the creation of two products A and B, the following information
is provided.

Activity Cost
Set-up 200000
Machine maintenance 90000

Total Manufacturing Cost 290000

Product A B Total
Number of setups 40 60 100
Machine Hours 1500 3500 5000

XYZ Company plans to produce 350 units of product A and 250 units of
product B. Compute the manufacturing cost for each product.

Solution:

First, we'll identify the company's operations, assigning costs to each one,
and then determine the cost driver for computing the allocation rate. We can
assign the coat to a product after calculating the allocation rate.

In the above case, the company performs two activities i.e. Setup and
maintenance of the machine.
Now, we will calculate the Allocation rate for each activity
1. Setup Cost:
Total Cost /Total No. of Setups = 2, 00,000/100 = Rs 2000 per setup

2. Machine Maintenance:
Total Machine Maintenance cost/ Total Machine Hour
= 90000 / 5000 hrs = Rs. 18 per hour
After determining the Allocation Rate, the next step is to allocate costs to
each product.
130
The following table shows the allocation of costs. Cost Centres

Activity Product A Product B

Setup cost per Setup × 2000 × 40 = 60×2000 = 1,20,000
No. of Setup 80,000
Machine Cost per Hour × 18 × 1500 = 3500 × 18 = 63000
Maintenance Machine hour 27000
Total Cost Rs 107000 Rs 183000

Calculation of Manufacturing Cost per Product:

Product A = Total Cost/[Link] units produced, = 107000/350 = Rs 306

Product B = Total Cost/[Link] units produced = 183000/250 = Rs 732

In the above illustration, we see that costs are allocated according to the
activities performed instead of a traditional volume-based approach.

Activity-based costing is hence very useful when different products are

manufactured and when there is a mix of simple and complex products.
Activity-Based Costing would also help identify costs which do not
necessarily add value to any process or activity and hence do not get
allocated directly to any activity. These costs have to be ultimately weeded
out. Hence the application of Activity Based Costing is vast.

When direct costs reduce due to increasing product or technological

complexities, discretionary spending increases and hence all the techniques
discussed in this Chapter would address this issue.

5.7 SOME SPECIAL DISCRETIONARY COST

CENTRES
Now we will take up some special type of discretionary cost centres like
Administrative and support services, R&D activities, and marketing services
(though some of these cost centres, to an extent, have been discussed in the
preceding sections).

Administrative and support service departments

Administrative services include senior corporate management, business unit

management, and managers who are responsible for their staff units. Support
services include units that provide services to other responsibility centres.
The control of administrative and support services (or centres) is especially
difficult because measuring output of such units is almost impossible; and
there are chances of dyfunctionality taking place (because of lack of goal
congruence).

The support departments like legal, or MIS may like to have the ideal system
which may be too costly when compared to the additional benefit they 131
Management generate. In a smal1organizations, the senior management is in personal
Control Structure
contact with staff units and can determine from personal observation what
they are doing and what is the worth of their work. In a large business,
however, senior management may know much and may, therefore, be not in a
position to properly evaluate the worth of their contribution. Discretionary
cost centres at the corporate level are the most difficult to judge in relation to
the objectives. To gauge the value of the output and to give the semblance of
measurability to their output, support services may be required to charge
other user departments (or responsibility centres) for the services rendered by
them.

R&D department

The control of R&D department, a discretionary cost centre, is difficult for

the following reasons:

a) It is difficult to measure results quantitatively, though, unlike

administrative and support departments, R&D units have at least semi-
tangible output in the form of patents, new products, new processes, etc.
Nevertheless, it is difficult to measure and appraise the relationship of
these outputs to inputs. Even if the value of the output can be calculated,
it is usually not possible for management to evaluate the efficiency of
R&D effort because of its technical nature.

b) The dysfunctionality problem is similar to administrative and support

units. The research managers typically want to build the best research
organization that money can buy, but for the company it may be difficult
to afford.

c) The R&D can seldom be controlled effectively on an annual basis. A

research project may take years to reach fruition, and the organization
must be built slowly over a period of time. When R&D budget is linked
to sales revenue or profits (based on a certain percentage), the allocated
amounts fluctuate year after year which may not be a healthy thing for
the organization. R&D should be seen as a long-term investment, and,
hence, the budget amount, as far as possible, should be stable over time.

There is no scientific way of determining the optimum size of R&D budget.

In progressive organizations, the amount of budget is specified as a
percentage of average revenue, rather than actual annual revenue, to impart
an element of stability to the budgeted amounts. The R&D programme in a
year generally consists of a number of projects plus a blanket allowance for
unplanned work (for basic or fundamental or exploratoiy research).After
the research committee has approved the projects, out of the long-range
programme, for the year, the preparation of the annual R&D budget is a fairly
simple matter. The annual budget ensures that actual costs will not exceed the
budget without management’s knowledge.

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Marketing Department Cost Centres

A marketing organization has three types of activities, and consequently,

three types of activity measures may be used. First, there is the amount of
revenue that the marketing activity generates. This is usually measured by
comparing actual revenue with budgeted revenue and comparing physical
quantities sold with budgeted units. Second, there is the order-filling,
logistics or distribution (transportation included) activity. Such costs also
include warehousing, shipping, delivery, billing and the related credit
function, and collection of accounts receivable. Many of the costs incurred in
these activities are engineered costs, and the actual costs can be measured
against standard or(flexibly) budgeted costs. Third, there are order-getting
costs (such costs take place before receiving the orders, contrary
to order-filling costs which take place after the orders have been received)
Which are discretionary, and the optimum amount cannot be known.
Consequently, the measurement of efficiency and effectiveness for these
costs is highly subjective.

While discussing the RA system, we had talked about two important

concepts: the concept of Management by Exception (MBE), and the concept
of Accounting Variance. We now briefly explain these two concepts.

5.8 CONTROLLABILITY VS. NON-

CONTROLLABILOTY OF COSTS
Controllable vs Non-Controllable Cost

Costs can be divided into controllable and uncontrollable costs. Standard cost
centres are usually responsible for the controllable cost in the responsibility
centre.

Controllable costs are those thatmay be monitored or regulated over a

specific period by establishing adequate processes and personal
responsibilities. For example, if the production supervisor is responsible to
hire labour daily, then labour cost is said to be controllable by the supervisor.

Non-controllable or uncontrollable costs are the costs which aren’t or cannot

be regulated by the manager irrespective of his authoritative position.
Suppose the factory is operating out of rented premises, and management
decides the place out of which factories operate and the factory head has no
authority in that decision, then factory rent will be an uncontrollable cost as
far as the factory head is concerned.

It must be remembered that every cost that is uncontrollable at some level is

controllable at a higher management level. So for the business as a whole, no
cost will be classified as uncontrollable for responsibility accounting.

It must be remembered that every cost that is uncontrollable at some level is

controllable at a higher management level. So, for the business as a whole, no
133
Management cost will be classified as uncontrollable for responsibility accounting.
Control Structure
Earlier it was stated that only controllable costs are relevant and are shown on
the Responsibility Reports. How do we determine whether a cost is
controllable or non controllable? There are two determinants of
controllability of costs:

1) Level of management responsibility.

2) Time span covered.

Level of Responsibility

Responsibility for incurring, and, therefore, for controlling, costs can be

traced to successive levels of the management hierarchy. The costs that are
non-controllable at one (or lower) level may be controllable at another (or
higher) level. The higher one goes in the organization chart, the more the
costs that can be controlled. To accomplish performance measurement, the
performance (or responsibility) reports should be so designed that only costs
that are controllable at a particular level are shown/reported. The reporting
must follow the organization chart. Before the responsibility structure is laid
out, the management must make a thorough review of the organization chart.
If any changes are made in the organization chart, the changes should be
reflected in the reporting system. The accounting data has to be accumulated
in accordance with the responsibility structure. The organization
chart is the vehicle for accumulating costs, expenses, and information to
satisfy the needs for management control.

Time Span

The second determinant of controllability is the span of time covered. Costs

which are non-controllable over a short span of time may be controllable over
a longer time span. Engineered costs which are mostly direct costs of
production are the result of decisions on current production levels and
respond quickly to changes in volume. While some fixed costs are
discretionary and result from management decisions on the short-run current
budget, other fixed costs are committed by past decisions which have a long
term effect. In addition to these examples of costs which result from
operations, the costs of capital expenditures and of major projects have an
important time dimension and are, therefore, controllable only over a
relatively long time span.

Time span is also a factor in allocating and controlling the costs of service
departments.
For example, a service department such as factory power will have
committed costs based on a maximum standby capacity assessed on the basis
of the needs of the user departments. Such committed costs are not
controllable in the short run.

It must be said that although it is common to speak in terms of controllable

134
and non-controllable costs, ultimately all costs are controllable and there are Cost Centres

no non-controllable costs. All costs are controllable by someone at some

time.

5.9 SUMMARY
For a Standard Cost Centre, the expected outcomes are cost control,
efficiency, quality of output and timeliness of delivery. The evaluation
measure is the Variance Analysis which is the comparison of Actual with
Standard. For a discretionary expense centre, Quality of Output is necessary
and performance is measured by checking compliance with pre-approved
budget spending limits. The performance of the Discretionary cost centre is
the most difficult to assess of all the responsibility centres. As a result,
methodologies such as the Balanced Scorecard, Zero-Based Budgeting, and
Activity-Based Costing are employed.

5.10 KEY WORDS

Zero Based Budgeting is where expenses or costs from the previous year are
not taken into account when establishing budgetary levels or expenses for the
coming year, and each expense category starts from zero.

Activity-Based Costing (ABC) is a cost estimation method that divides a

project into, quantifiable activities, discrete or units of work.

5.11 SELF ASSESSMENT QUESTIONS

1. How is the performance of various responsibility centres evaluated?
2. Explain how performance evaluation is done in a standard cost centre.
3. Why is performance evaluation in the Discretionary expense centre
difficult?
4. Explain Zero Based Budgeting and how it helps in the performance
evaluation of a Discretionary Expense Centre?
5. How do we evaluate an Investment Centre?
6. Explain Activity-Based Costing.
7. State whether True or false:
a. All negative variances are necessarily problematic.
b. Any cost centre exceeding budgetary allocation is not performing
well.
c. Zero Base Budgeting assumes all base costs to be zero.
d. Profit centres are not responsible for Return on Investment.
8. State whether True or False
a. The basis of Activity Based Costing is that products add to cost
b. Pricing distortions can happen when costs are distributed without
tracing the activity drivers.
135
Management c. When most of the costs are direct, Activity-based costing is very
Control Structure
useful.
d. Activity Based Costing helps in bringing down product costs in the
long run by identifying non-value added costs.

5.12 SUGGESTED READING

Anonym. (2019). Management Control Systems: Different Types of Control
Management. On the Effectiveness, the Advantages and the
Disadvantages. Germany: GRIN Verlag.

Hoozée, S., Bruggeman, W., Slagmulder, R. (2018). Management Control:

Concepts, Methods and Practices. United Kingdom: Intersentia
Nilsson, G., Anthony, R., Hartmann, F., Kraus, K., Govindarajan, V. (2020).
EBOOK: Management Control Systems, 2e. Spain: McGraw-Hill Education.
.
Schmidtlein, F. A. (1999). Assumptions underlying performance based
budgeting. Tertiary Education & Management, 5(2), 159-174.

Wetherbe, J. C. and Montanari, J. R. (1981), Zero-based budgeting in the

planning process. Strategic Management. J., 2: 1–14.

136
UNIT 6 PROFIT CENTRES Profit Centres

Objectives

After going through this unit, you should be able to:

• understand the meaning and significance of profit centres;

• appreciate the relationship between corporate philosophy and style, and
profit centre autonomy, and between diversity and decentralization;
• understand the rationale behind the establishment of profit centres, and
distinguish between genuine and artificial profit centres;
• explain the benefits and limitations of profit decentralization, and how
the difficulties arising from operationalizing this concept could be
overcome;
• appreciate the popularity and motivational value of profit centres;
• describe the various methods for measuring profitability of profit centres;
• understand the process and issues involved in setting up profit targets,
budgeting, reports, and analysis of profit centre results; and
• explain the aspects and issues involved in performance appraisal.

Structure
6.1 Introduction
6.2 Profit Centres
6.3 Corporate Philosophy and Style, and Profit Centre Autonomy
6.4 Diversification and Decentralization
6.5 Benefits and Limitations of Profit Decentralization
6.6 Making Success of Profit Decentralization
6.7 Establishing Profit Centres
6.8 Boundary Conditions for Profit Centres
6.9 Prevalence of Profit Centres
6.10 Motivational Value of Profit Centres
6.11 Genuine and Artificial Profit Centres
6.12 Performance Measurement of Profit Centres
6.13 Target Profit, Budgeting and Reports
6.14 Analysis of Profit Centre Results
6.15 Performance Appraisal
6.16 Summary
6.17 Keywords
6.18 Self-assessment Questions
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Management 6.19 Further Readings
Control Structure

6.1 INTRODUCTION
The purpose of the present unit is to familiarize you with the various aspects
and issues involved in profit centre structures in a business organization.
What is a profit centre is first defined? This is immediately followed by a
discussion about the relationship between corporate philosophy and style, and
profit centre autonomy. It is essential to give this as a backdrop to a detailed
discussion about the various facets of profit centres so that you are able to
appreciate the rationale behind the creation of profit centres and examine the
issues in proper perspective. The linkage between diversity and profit
decentralization is explored. The unit then discusses benefits and limitations
of profit decentralization. It also suggests the ways and means by which most
of the difficulties could be overcome to make a success of profit
decentralization. How far the profit centre concept is popular and whether
profit centres have motivational value are examined.

The unit then proceeds to distinguish between genuine and artificial profit
centres. The various methods of determining profitability of profit centres are
explained. The process of setting profit targets, planning and budgeting, and
problems in reporting profits are explained. Finally, the unit analyses and
discusses the issues involved in the analysis of profit centre results and
performance appraisal.

6.2 PROFIT CENTRES

Profit centre is a responsibility centre in which financial performance is
measured in terms of profit which is the difference between the revenues and
the costs (or expenses). Profit as a measure of performance is considered
more useful since it is one comprehensive measure that dispenses with the
need to use several measures, e.g., profit margin, asset turnover, etc. Profit is
the most widely used measure of performance for a business firm, and hence,
therefore, not surprising that profit centres are popular among large
decentralized organizations.

The above definition of profit centre is at a purely descriptive level, that is,
profit centre is an organizational unit for which some measure of profit is
determined periodically. But this definition fails to capture the purpose
behind the establishment of profit centres which is to encourage local
decision making and initiative. Merely assigning prices to the output of a
unit, or attributing costs to the inputs (or goods) to a unit, does not make the
unit autonomous or independent. From this perspective, profit centre is a unit
for which the manager has the authority to make decisions on sources of
supply and choice of markets. In general, a profit centre to be truly called as
such is the one that is selling a majority of its output to outside customers and
is free to choose sources of supply for a majority of its materials, goods,
parts, components, services, etc.
138
A question may often arise whether a company should treat a segment as a Profit Centres

profit centre or as an investment centre (the latter is discussed separately in

Unit 7). In fact, a business enterprise may have choice to establish a segment
either as a profit centre or as an investment centre (in an investment centre
the manager has an added responsibility for a return on assets used in his/her
centre). However, profit centre is an appropriate structure for an
organizational unit if fixed or productive assets like plant and equipment are
stable from year to year and not controllable by the profit centre manager.
For example, if all the capital expenditure decisions have been made
or are being made at the top management level, then the profit centre
manager cannot be supposed to be controlling the level of investment and,
therefore, should not be held accountable for the past decisions on plant and
equipment.

6.3 CORPORATE PHILOSOPHY, STYLE AND

PROFIT CENTRE AUTONOMY
How much or what degree of autonomy the profit centre or divisional
managers will have depends on several interrelated factors, as depicted in
Figure [Link] autonomy of the manager refers to the freedom (or latitude)
the manager has in decision making and is affected by the constraints placed
upon the manager by his/her superiors.

Corporate Structure Measurement

Strategy (Responsibility System
Structure)

Corporate
Philosophy Custody
(Mission & Management of Autonomy
Vision) Style Resources
Reward
System

Policies
&
Procedures

Figure 6.1: Decentralized Management and Profit Centre Autonomy

There is a difference between intended autonomy and perceived autonomy.

Intended autonomy of managers is what is formally contemplated (or
provided for) by the organization through its structure, policies and
processes. But perceived autonomy is what as a matter of fact is perceived to
actually exist, by a manager. If intended autonomy can be regarded as
theoretical, then perceived autonomy can be considered as the actual or
practical autonomy; and the two types of autonomy may be found at
variance with each other in real practice.
139
Management Autonomy is a dynamic concept and may not be the same for all the times.
Control Structure
Further, the autonomy of one manager may be different from the other in
terms of quantity and quality; even though they are managing similar kind of
units. Corporate management influences profit centre managers through a
network of relationships that lay down the domain in which the manager has
the freedom to take whatever action s/he deems appropriate in regard to the
responsibilities that are placed or expected of him/her.

The root of several factors shown in Figure 6.1 is the corporate philosophy,
i.e., the philosophy of the promoter(s), or the CEO/President/Managing
Director and a group of top managers around him/her. Together they may be
called the top management/corporate management: Several other factors,
shown on the right side of the corporate philosophy are usually the offshoots
of the latter. It is the corporate philosophy that" influences the vision and
mission of the organization. Corporate philosophy affects the strategy and
management style. What responsibility structure (or simply the structure)
policies and procedures the company will have are largely determined by the
strategy of the organization and the management style of the corporate or top
management. Whether there will be centralization or decentralization of
decision making is largely influenced by the corporate management style
which may be either autocratic or democratic. However, the two management
styles- autocratic and democratic should not be seen in black and white; there
may be several shades of grey between the two extremes. It is the style of top
management that influences the design of several management systems,
including the management control system, planning, performance review
systems, frequency of meetings, etc. “Style determines just how tightly the
screws are on managers”.
The managerial style consists of several personal variables that influence the
behaviour of corporate management. These variables include:
(i) the desire of the corporate managers to be involved in the details of
the business of units and their day-to-day interaction with profit
centre managers; and
(ii) the level of trust and confidence the corporate management has in the
ability and experience of managers.
The responsibility structure, policies and procedures that the corporate
management has laid down usually affects the custody of resources
(physical/material, human, financial, etc.), i.e., what resources and to what
extent the profit centre managers will have them? The measurement and
reward system are largely affected by the responsibility structure. The
rewards, as you might be aware, consist of tangible and intangible rewards.
All the above variables that we have just discussed produce an ultimate effect
known as “autonomy” of the profit centre manager, though the immediate
ones are the responsibility structure and the policies and procedures, and the
degree of custody of resources.

140
6.4 DIVERSIFICATION AND Profit Centres

DECENTRALIZATION
Autonomy is co-extensive with the strategy of diversification. That is, more
the enterprise diversified more the autonomy its units tend to have.
Diversification tends to bring about the establishment of almost autonomous
or semi-autonomous (as they are usually called) business units/divisions
which have within them both the major functions of manufacturing and
marketing, i.e., the responsible managers or heads of the divisions take
decisions with respect to manufacturing and marketing operations, and hence
can be held responsible for generating certain levels of profits (or targeted
agreed profits).

One of the purposes of decentralization is the economic efficiency which

means utilization of resources to achieve maximum possible benefits. If a
segment is to be economically efficient, it should follow the same patterns of
behaviour that are found in independent entities competing against each
other. When profit responsibility which otherwise exists at the corporate (or
highest level) percolates down to the business unit or divisional level, the
process is known as profit decentralization. The responsible managers of the
business units or divisions take upon themselves the responsibility of
contributing profits to the overall/collective profits of the organization. The
responsibility for generating the overall organization profit is spread across
the business units or divisions, and is not just concentrated at the apex or top
level.

As a natural consequence, diversification leads to what is called

divisionalisation which in turn facilitates profit decentralization and the
establishment of profit centres. The divisions (or better known as product
divisions) are more or less independent business units. It happens because
they are in different industries and there is very little interdependence
between them. The complexities in business emerge as the firm moves from
single-product, single-plant to multi-product, multi-plant to multi-industry,
multi-location in stature. As the firm moves along this spectrum, the
broadening of the managerial perspective, including managerial control, is
required.

A diverse organization needs different approach to management and control.

The diversity may arise from many factors:

• Some business units have short product cycles, while others have long
cycles;
• Some units are serving consumer markets, while others the original
equipment mmanufacturers;
• Some units are serving domestic markets, while others international
markets;
141
Management • Some units have labour-intensive production while others have material-
Control Structure
intensive;
• Some units are operating in regulated markets, while others in
unregulated markets;
• Some units have their objective as harvest/divest, while some others have
invest/grow; and
• Some units have many competitors, while some others have few or a
small number of competitors.

The diversities mentioned are just a few ones meant only to illustrate the
idea. In the real business world, there are many more diversities arising from
a plethora of factors. All these diverse issues need to be properly addressed if
the total business activity is to be successful. It is apparent that a single
manager may find it difficult to focus on this diversity on a day-to-day basis
without some loss of control. The outcome would be less than optimal in
terms of achievement of objectives of the total business, including
profitability. Such conditions warrant that profit responsibility be
decentralized.

6.5 BENEFITS AND LIMITATIONS OF PROFIT

DECENTRALIZATION
An organization can reap several benefits from profit decentralization; but
profit decentralization may also give rise to several difficulties which the
management has to resolve before they crop up. It is in this context that the
proper design of profit centre structure is of paramount importance.

Benefits of Profit Decentralization

The following benefits are usually claimed when profit responsibility is

delegated along profit lines to the units of the enterprise called profit centres.

• Better understanding about firm’s ultimate objectives: The greatest

advantage of profit decentralization is that it brings the unit managers
into more direct contact with the ultimate profit objectives of the firm.
The managers develop better understanding of what profit is all about.
Profit is a better motivator of managers. A manufacturing-oriented
manager views all problems as production problems with cost as a
dominant factor, whereas a marketing manager is haunted with sales
increases. In a functionally organized firm, the broader viewpoint comes
only at the top of the pyramid. Through profit centres this broader view
can be engendered at the lower levels.
• Better profit planning: As a corollary of the preceding point, profit
decentralization enhances the profit consciousness of the managers. It
motivates managers to look for ways and means to improve profitability
of their units and thus promotes more effective control. There is more
142 emphasis on better profit planning through efficient budgetary methods
 and processes, administrative controls, and reporting systems .Every Profit Centres

manager who is concerned with working out a profit plan, at the end, is a
manager with better understanding of the factors that contribute to a
good performance.
• Better morale and motivation: Profit decentralization has a stimulating
effect on the morale of the key men in each of the units designated as
profit centres. It fulfills the managers’ needs for sharing responsibility on
a higher plane and at a larger platform which is in accordance with the
job enrichment recommendation of Motivation Theory. The managers
have a greater degree of freedom and exercise control over a wider
horizon. They can be more imaginative and take initiatives.
• Better quality of managerial decisions: Perhaps the most important
benefit is its potential for improving the quality of managerial decisions.
Decisions can be taken swiftly and effectively by managers who have
closer familiarity with individual products, markets and the external
environment. Problems of communication are minimized. Managers
learn to be more flexible and adaptable.
• More attention by corporate management on strategic aspects: Profit
centre structure relieves the top management from day-to-day operating
decisions, enabling them to devote more time and attention to strategic
planning and overall direction of the business enterprise. The corporate
management can assume the more entrepreneurial role which is what is
needed in today’s competitive environment. Burden of decision making
is distributed throughout the organization.
• Training ground for developing a cadre of general managers: As
decision making is done on a wide spectrum, profit decentralization
provides a fertile training ground for development of general managers
with broad understanding. It provides a good opportunity for evaluation
of divisional managers’ abilities for higher management positions.
• Encouraging a spirit of competition: It encourages competition where
units are identical and performance is comparable. A reward system
geared directly to profit performance can become a motivating source for
taking initiatives for better performance.

Difficulties with and Limitations of Profit Decentralization Profit

Centres

The approach underlying the establishment of profit centres is that if each

unit acts as a profit optimizer, the total profit of the organization will be
optimized. But the logic may break down because decentralized decisions
may not necessarily produce optimum overall results. Profit decentralization
has its own side effects and could be subject to a range of problems peculiar
to the concept itself.

• Costly form of organization: Administratively, such a structure may

143
Management turn out to be an expensive form of organization. Some staff and support
Control Structure
activities, and also record keeping tend to be duplicated; as they are
found at both the levels, viz., at the corporate as well as divisional level.

• Necessary restraint difficult: In theory, a company creates profit

centres because it has decided to delegate more authority to managers of
the operating units. More authority means more freedom and flexibility
in decision making to managers of profit centres and no or least
interference by corporate management in day-to-day working. But it may
be difficult for the top management to exercise restraint/ discipline on
themselves if they have earlier been used to this kind of management
style.

• Frictions and dysfunctionality: The profit centre system may give rise
to certain complications and frictions within the organization. A
tendency of dysfunctional decision making may be observed. As a result
the benefit to one unit may be more than offset by the costs or loss of
benefit to other unit(s) or the company as a whole.

As a student of management you are aware that an organization is more than

the sum of its parts. The dysfunctionality arises because of lack of harmony
or congruence between overall organizational goals and individual goals of
profit centre managers. The managers of some profit centres may not
appreciate the effects of their decisions on other units/profit centres. The
profit centre manager may not like or be inclined to spend an adequate
amount on advertising, or training of workers and employees, or on quality,
or on research and development because all these expenses have a long term
effect; their results are felt only in the long run. But over a short run, they
have the effect of reducing profitability of their units. However, from the
company’s long term point of view, the incurrence of such costs should take
place, rather than being avoided. Such a practice takes place if profit centre
manager thinks that by the time the results of such costs come in, s/he may
not be around (not unimaginable in today’s conditions when job hopping has
become quite common).

• Bickering on transfer prices: Where interdependence exists between

profit centres because of integrated nature of business or because the
boundaries of profit centres have not been carved out neatly and
unambiguously, frictions may arise. Under conditions of
interdependence, profit centres cannot be created unless the mechanism
of transfer pricing (goods and services transferred from one profit centre
to another at a price) is set into motion. While the transfer price
determined may suit one profit centre manager, it may be found totally
unsuitable (and hence unacceptable) to another profit centre manager
(You will study more about transfer pricing in another unit). This gives
rise to bickering and frictions which is not a healthy thing for the
organization as a whole. Therefore, as far as possible, profit centres
144 should be self-contained, with no or minimal interdependence. But this is
 easy said than done. Profit Centres

• Difficulties arising from common costs: In any organization, there are

certain joint and common costs (the example of the latter is the support
services organized centrally at the corporate office) which have to be
allocated (for calculating profitability of individual profit centres) to
various profit centres on a justifiable basis, and often this presents
ticklish problems. All profit centre managers may not agree to the
allocations made.

• Unhealthy competition: Emphasis on the “bottom line” as a yardstick

of performance, without considering other factors, may lead to unhealthy
competition which may be at the cost of cooperation which is also
required for long term growth of the business as a whole.

6.6 MAKING SUCCESS OF PROFIT

DECENTRALIZATION
For making profit centre structure effective and successful, it is necessary
that attention is paid to the following points:

• Minimum interdependence: There should be, as far as possible,

minimum interdependence between the profit centres. Profit centres
should be self-contained., with production and marketing facilities so
that there is minimum need for internal transfer of goods and services.
Only then will the performance of the profit centre reflect the true
profitability of the segment as it will be independent of the operating
performance of other segments. But this ideal condition is seldom
feasible in the real world, unless the company is willing to sacrifice the
advantages of size and synergy. Earlier we had noted that certain support
services tend to be centralized at headquarters to reap the benefits of
economy, efficiency and specialization. Besides, there are certain
industries which are of integrated nature, e. g., oil industry where
independence of units is almost impossible.
• Minimum direct competition in outside markets: The management
should see that, as far as possible, the profit centres do not compete with
each other at the marketplace, because the gain of one profit centre may
be at the cost of another profit centre. This may be achieved by drawing
the boundary lines of profit centres in such a way that the necessity of
competition with each other does not arise.
Operational autonomy: Each profit centre should be an independent
operating unit in the sense that the responsible manager should have
control over his/her input and output decisions. Only then will the profit
reflected in earning statement of the centre will be a true indicator of the
performance of the centre. However, in the real world, constraints are
imposed on the autonomy of profit centres because of
(i) strategic needs and considerations; 145
Management (ii) economies of centralization; and
Control Structure
(iii) considerations of uniformity. For example, profit centres often do not
have the authority to raise capital in the market. It was just pointed out
that most of the staff and support services like legal, public relations,
economic forecasting, information management systems, etc. even in
large diversified firms, tend to be centralized for obvious reasons. Then,
uniformity considerations require conformity to accounting and
management control practices, personnel and industrial relations policies,
human resource policies and practices, etc..
• Rational transfer pricing system: Since complete independence of
profit centres is only a utopian thought, and some amount of
interdependence is inevitable in any profit centre structure which makes
transfer pricing a necessity, it is desirable that the transfer pricing system
should be evolved in such a manner so that it has the agreement of all
profit centre managers. Otherwise, profit of one profit centre may be the
loss of another one. Transfer prices negotiated between the two
transacting profit centres are regarded as ideal as they are considered as
arm’s length transactions. But this is possible only where the parties
involved are in equal bargaining position, and where the factors affecting
inputs and outputs are well within the control of profit centre managers.
Again, the real world situations defy the ideal and some kind of
arbitration or intervention by the central staff becomes necessary.
• Non-interference policy: The central or corporate management must
believe in the philosophy of decentralization and should have trust and
confidence in the profit centre managers. They should desist from
interfering in day-to-day affairs of profit centres, that is, they should
have patience and deal with centre managers with understanding. They
should act as guides, counselors or mentors, rather than as commanders.
• Emphasis on long term profitability: Whether someone likes it or not,
some degree of short-term orientation is built into the system of profit
centre system. Short-term profit may be at the cost of long-term profit
which is not in the overall long-term interest of the company. It is,
therefore, necessary for the company to inculcate a long-term view
among the profit centre managers; and here, example is better than
precept. The corporate management, through their own conduct, set an
example for profit centre managers to emulate. If the central
management puts too much pressure on the profit centre managers for
higher and higher profits, the latter would use whatever weapons they
have at their command to raise their short-term profits by any means,
even though, ironically, they may be aware that what they are doing is
not right and is at the cost of long term profitability of the enterprise.

You must have noted that when we consider the real world, some constraints
on the autonomy of profit centre managers are almost unavoidable. If the
profit centres are to be completely independent, then the best way is to
146
convert them into independent or separate companies. But, for obvious Profit Centres

reasons, this course may neither be desirable nor practicable. After all, central
management cannot abdicate their responsibility by delegating full authority
to divisional managers, as they are accountable to shareholders and other
stakeholders. Consequently, there are trade-offs between corporate
constraints and profit centre autonomy.

Further, you earlier noted that some interdependence between profit centre
managers is unavoidable which may result from the nature of the enterprise,
type of the organization structure, etc. The result of all this is that profit
centre managers do not have control over ill factors (product decisions,
procurement or sourcing decisions, and marketing decisions, etc..) that affect
their performance.

Additionally, you also noted that some constraints are imposed by central or
corporate management which are necessitated by strategic considerations,
considerations of economical operations, and considerations to ensure
uniformity in certain important matters.

In designing the management control system in relation to profit centres, it is,

therefore, imperative to incorporate these constraints so that profit centre
managers are informed about them and do not have unrealistic expectations
of the operation of the system. So long as the constraints are dealt with
explicitly, they may not cause much problem in decentralization. If the profit
centre managers understand the necessity of the constraints, they would
accept them as though they are part of the game. Often they feel bad for any
internal (chargeable) support services for which they pay but are otherwise
available more efficiently and at lower cost from outside.

6.7 ESTABLISHING PROFIT CENTRES

Profit centres are established as a result of the decision of the top
management, i.e., profit centres come into being because the top management
thinks that it would be a good idea to designate all or some units of the
organization as profit centres, and hence it creates such entities. As discussed
in the preceding section there are organizational units which are naturally
suited to a profit centre structure because managers in such units can take
decisions which involve revenue-cost tradeoffs, for example, whether the
incurrence of additional costs would result in additional revenue or not, and if
it will, then to what extent? To take another example, whether the increased
expense on quality control will result in more satisfied customers, and hence,
in increased revenue? However, the manager:
i) Must have the relevant information to make such trade off decisions; and
ii) There should be some way to measure how effectively the manager is
making the trade offs.
In case these two conditions are not met, the units are not the natural
candidates for establishment of profit centres. Yet the management may 147
Management like and decide to designate such units as profit centres (but truly
Control Structure
speaking, they are artificial profit centres, a topic which will be taker, up
for discussion a little later).
An efficient profit centre should have the following characteristics:
• Operational independence: The manager should have control over its
operations and be free to make decisions concerning such questions as
the volume of production, methods of operation, product mix, etc.
• Access to sources and markets: The manager should be free to buy and
sell in alternative markets, both inside and outside the company. Where
freedom to trade is absent, the buying or selling profit centre managers
have little incentive to reach (optimal) decisions.
• Separable costs and revenues: The profit centre should have costs and
revenues that are separable from other segments of the company. It
should be able to identify all costs and revenues which are measurable.
• Management intent: A profit centre should be established only when
the overall goal of management is profits for the segment, and the
management has the intention to treat the segment this way.

To sum up, the rationale behind the creation of profit centres is that the
organization will function more efficiently when it is subdivided into a
number of independent units which operate as economic entities. The attempt
of each sub-unit to maximize its own profits will result in a high degree of
efficiency and productivity, and will have the same advantages as are found
for individual independent entities operating in a competitive economy.

In the previous unit, we have briefly discussed the various forms of

organization: Functional, Product Divisions, Matrix, etc. While in a single
industry enterprise, the natural structural choice is a Functional organization,
in a multi-industry enterprise the natural structural choice is product
divisionalization, i.e., divisions based on major industry based products.
However, a functional structure is not precluded even in the latter type of
organizations. At some level even product divisions have functional
organization.

It would not be an exaggeration to say that all enterprises are organized

functionally at some level.

For a company to have profit centres, it must have two or more units/
divisions for which separate profit measures are obtained.

6.8 BOUNDARY CONDITIONS FOR PROFIT

CENTRES
In companies where each of the principal function of manufacturing and
marketing is performed by separate organizational units, these type of
companies (organizations) are known as functional organizations. As the
companies expand and mature over a period of time offering diverse products
148
and services, it becomes difficult for top management to pay equal attention Profit Centres

to all products and services. In this scenario one of the option available is to
divisionalize the company which implies that each major organizational unit
in the company is responsible for both the manufacturing and the marketing
of the product, implication of this move is that there is greater amount of
delegation of authority and responsibility to the operating managers.

An organization with several divisions is a complex as a whole. Thee

divisions, however, are not separate entities in their own right. The design of
profit centres in organizations will have to contend with the question of
service functions centrally located in the headquarter which do not directly
contribute towards performance of profit centres. We also have to consider
the domain of the profit centre. Thus, defining the boundary conditions for
the profit centres is an important aspect of the design of profit centres.

The major problem associated with the service functions is that there is no
direct measures of profit which can satisfactorily evaluate the performance of
the function. Even though the service functions are very important in the
profit performance of the company as a whole, it is very difficult to isolate
and measure their contribution. It may be possible to organize many service
centres into profit centres and their services could be sold, but in most
organizations they are intended to provide their services only to the
organization. Their services may not be used in sufficiently large volume if
they are organized as profit centres. The examples of service functions are
management information service, legal services, corporate planning
department etc.

A plausible solution is to distribute the cost of service functions among

various profit centre where such activity can be economically justified.

The major problem is to define the boundary conditions for the profit centre
where by we can balance the costs and revenues of the division. The major
objective of the exercise is to ensure that we maximize certain revenues and
minimize certain costs. Therefore, measurement of profits as the outcome
becomes the major criteria in decision making within the division. This leads
us to the most logical choice of accepting profit performance measurement as
the major factor guiding the determination of profit boundaries.

However, we should not lose sight of the fact that what is good performance
of the division need not always be the good performance of the company as a
whole.

Further, the profit centres should not result in conflict with other divisions
within the organization. These conflicts to occur in organizations when the
divisional managers in their eagerness to achieves profit in their division lose
track of the interest of other divisions. Appropriate boundaries for profit
centres thus would ensure a more meaningful profit performance of the profit
centre managers and act as better incentive.
149
Management Economic basis of the profit centre boundary revolves around factors such as
Control Structure
market for the product, cost and revenues structure and the separability of
their cost and revenues from the rest of the organization, management
objectives and above all the extent of operational freedom that is available.

Access to the market is very important with respect to profit centre

performance in that the choice of market, adaptation of the product to market
are necessary for maximization of revenues.

Cost and revenues are separate from the rest of the organization and the
ability to influence them by the decisions of the division is a necessary
condition for influencing profit. A manager should be evaluated only on the
basis of items over which he has control. If most costs and revenues are not
separable and controllable part of this is too small, profit centre may not be of
much use.

Management must be willing to accept the profit performance of the division

and be prepared to guide the decisions of the profit centres without curtailing
their freedom. It should be borne in mind that profit alone could never be the
sole criteria for evaluation of the performance of a profit centre.

All aspects considered, however, rightly demarcated boundaries of profit

centres will not produce any tangible to the organizational unless the
divisions have a reasonable measure of operational autonomy. The autonomy
will have to be clearly understood within the context of overall rules of the
game established by the top management.

Autonomy is crucial in decision areas such as buying, production and its

scheduling; inventory policies, choice of market, product mix and pricing

Activity 2

1) Try to prepare a check list of the boundary conditions for the

establishment of profit centres in an organization.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
2) List down the organization requirements for the establishment of profit
centres.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

150
6.9 PREVALENCE OF PROFIT CENTRES Profit Centres

Profit centre system (or profit decentralization) has been a key concept in
organizing large corporations in the United States, such as General Motors,
General Electric, DuPont, etc. where the companies established separate
divisions for each of their major products or product lines. General Electric
has more than 150 separate profit making entities. By no means confined to
the industrial giants in the United States, profit centre structure has been
found very well suited to smaller companies like Johnson and Johnson and
Abex Corporation. The idea underlying profit centres has been applied by
distributive trade, such as departmental and chain stores which place
all their operations in each region on a profit centre basis.

Drucker observed that in an organization that is too big to remain

functionally organized, horizontal federalism (represented by profit centre
approach) is often the answer, and a company which is too big and at the
same time too integrated to be genuinely decentralized, simulated
decentralization (giving rise to artificial profit centres) is often the
organizational answer. Under this arrangement, one function, one stage of the
process, or one segment is set up as if it were a distinct business with genuine
financial responsibility, usually in terms of profit. For all its difficulties and
frictions, simulated decentralization as an organization design has grown fast
these days.2

According to Vancil, managerial decentralization had become a universal

practice by 1970. Certain economic and social forces have contributed
towards this trend. The growth in the size of business firms and their
complexity, professionalization of management, and most importantly, the
strategy of diversification, and mergers and acquisitions have been the
impelling forces that lead to divisionalization which in turn gave impetus to
the adoption of profit centre approach. The newly created businesses under
the strategy of diversification or the newly acquired (or taken over)
businesses are retained as semi-autonomous or independent units respectively
in the shape of profit centres.

A 1966 survey of companies in the manufacturing and non-manufacturing

sectors in the USA found 82% of the respondents using profit (or investment)
centre idea. From 1970s to 1990s, three more surveys were conducted in the
USA by different researchers about the use of profit centre idea in American
industry. The findings of these surveys are summarized in Table 5.1.

Calculation of mark-up under the arm’s length agreements:

Table 6.1: Use of Profit Centres
Reece & Cool Vancil Govindarajan
(1978) (1979) (1994)
No. of usable responses 620 291 638
151
Management Companies with two or more 96% 94% 93%
Control Structure
profit centres
Sources:
Reece, James S. and Cool. William A, Measuring Investment Centre Performance, Harvard
Business Review, May-June 1978, pp. 28-49.
Vancil, Richard F., Decentralization: Management Ambiguity by Design, Dow Jones-Irwin,
1979, p. 169.
Govindarajan, V., Profit Centre Measurement: An empirical Survey cited in Anthony, R. N.
and Govindarajan, V., Management Control Systems, Tata McGraw-Hill, 1999, p. 172.

The above surveys clearly indicate that profit centres have been used as a tool
of management control throughout all this period. The survey results from
India (see Table 6.2) also indicate a heavy reliance on the profit centre
concept. Table 6.2 summarizes the findings of the two surveys conducted in
India.

Table 6.2: Use of Profit Centres

Govindarajan & Bhatia

Ramamurthy
(1983) (1986)
Number of usable responses 105 65
Companies with two or more profit 65% 71%
centres
Sources:
Govindarajan V. and Ramamurthy B„ Transfer Pricing Policies in Indian Companies: A
Survey, The Chartered Accountant, Vol. XXXII, 5, Nov. 1983, pp. 296-301.
Bhatia, M. L., Profit Centres: Concepts, Practices and Perspectives, 1986, Somaiya, p. 75.
$ This is subject to the Note under Reference 4 (Please see References).

Whereas the survey by Govindarajan and Ramamurthy was undertaken

mainly to find transfer pricing practices in Indian companies, the multi-
faceted study by Bhatia was conducted to examine some important aspects of
the profit centre system in the contextual framework of Responsibility
Accounting, in particular the aspects relating to the incidence of profit
decentralization, organizational dimensions, and the practices used for
performance measurement and evaluation of profit centres in the large Indian
private corporate industrial sector.

There is not much difference in the incidence of the use of profit centres, as
the findings of the two studies indicate. Compared to 68% of the 1st study,
the 2nd study revealed 71% (however, this is subject to the Note-Reference 4
under References) of the respondents using the profit centre idea, either alone
or in conjunction with the related investment centre idea.3 4

Despite the criticism of the use of financial control systems during the past 20
years or so in the USA, corporations have not abandoned such systems. In
fact, financial controls continue to be used by corporations as tools to
implement strategies. It appears that companies are aware of the
shortcomings of financial controls and, therefore, employ other techniques as
152
well, e.g., balanced scorecard. The performance appraisal of managers and Profit Centres

the units of the companies are not just confined to a single method but to a
slew of methods and techniques to yield a balanced review of operations.

6.10 MOTIVATIONAL VALUE OF PROFIT

CENTRES
There has been a controversy about the usefulness of profit centre approach,
especially where profit centre are artificially established. For instance, it has
been argued that incorporating the profit centre approach or transfer pricing
into a management control system is undesirable as it serves no useful
purpose. From time to time, though, some writers have made observations
supporting the profit centre approach, and their main argument has been that
profit centre idea has a motivational value. That is, if a unit of the company is
regarded as a profit centre, instead of a cost centre (or revenue centre), the
manager of such a unit feels that s/he has been given a higher status by the
management and his/her abilities have been recognized. It has also been
suggested that managers at the middle level get more satisfaction from being
associated with a sub-unit called a profit centre rather than a cost centre even
though they may have no control over the profits they are reporting.

The assertions supporting the motivational value of profit centres seemingly

assume that from the viewpoint of behavioural and psychological
considerations, profit centres Transfer Pricing have a greater merit than cost
centres.

A multi-faceted study on profit centres and performance evaluation tested

this proposition found in the assertions made from time to time on the
motivational aspects of profit centres. In highly diversified companies which
operate in several industries, divisionalization comes more or less
automatically, and hence, such companies are easily adaptable to the profit
centre idea. The difficulty arises in those companies which are not
diversified, that is, they are single-industry companies manufacturing a single
product, or a product line in that industry. Such companies usually have
functional organization. There is often considerable to substantial
interdependence between the units of such organizations. If they were to be
tuned into profit centres, intricacies, including difficulties in the measurement
of their performance would arise due to interdependence, etc.

The manufacturing department, for example, in a functional organization is

usually treated as a cost centre, and the marketing department as a revenue
centre. If these two departments have to be made as profit centres (despite the
fact that they do not meet the second of the criteria of “Factors which can be
controlled” discussed in Unit 4 for designating responsibility centres), then
transfer prices for the transactions between the two departments will have to
be established. The goods produced by the manufacturing department will be
153
Management transferred at the transfer price to the marketing department. While the
Control Structure
transfer price for the manufacturing department is the selling price, for the
marketing department it is the purchase price. What should be the transfer
price and how it is fixed will have a direct bearing on the profitability of the
two departments (now turned into profit centres) it also influences the
behaviour of the profit centre managers. It could also be said the profits of
these two (artificial) profit centres created through the device of transfer
pricing (till the other day they were departments and as cost centres) will be a
function of the transfer price; however, fixed or settled. Earlier we discussed
that such situations could give rise to bickering and frictions among profit
centre managers, besides presenting difficulties in determination of
profitability of the segments and control responsibility of the managers.

An in-depth study on the motivational aspect, interestingly, revealed that

almost all such companies with highly interdependent units believed that
profit centre approach on the whole was a useful device (for different
reasons, though), in spite of the difficulties encountered from
interdependence and the establishment of transfer pricing. When asked about
the various dimensions of the motivational value of profit centres, it was
found that –

• Nearly two-thirds (66%) of the companies studied believed that the profit
centre system brought the centre managers more in line with the overall
company profit objectives and thus broadened their vision.
• 71% of the respondents believed that profit centres enhanced profit
consciousness among managers and stimulated better profit planning
processes.
• 48%of the respondents agreed that profit centres created a sense of pride
among managers and thus it fulfilled their higher level psychological
needs of self-esteem and self-actualization.

From the above findings it is, therefore, evident that views of the companies
on one aspect of the motivational value of profit centres that the system
fulfills the higher level psychological needs of the managers are sharply
divided. However, there was a broad support for the other two motivational
dimensions that profit centres brought the managers more in line with the
overall company objectives and that they enhanced profit consciousness
among managers and encouraged better profit planning.

Profit centres play an educational role as they are viewed as a means of

orienting segment managers towards the same objectives as of the overall
company, i.e., a concept of profit. In other words, the profit centre system
broadens the vision of the managers which the cost centre approach is unable
to accomplish. The idea behind the creation of profit centres using transfer
pricing which may lie outside the control of profit centre managers is
apparently to educate them to view internal prices as external constraints on
their operations. Needless to say constraints exist at all levels of management,
154
and managers particularly at higher levels operate under environmental Profit Centres

constraints of varying nature. In the present conditions, managements today

have no other option but to learn to live with these constraints. Middle
management begins to appreciate the need for constraints on their freedom.
Seen in this context, profit centre system serves a purpose as it can prepare
managers for higher positions whenever opportunities arise.

The behaviour of the divisional managers is often heavily influence by how

their performance is measured. Thus, profit centres act as a tool for
motivating such managers. However, it is quite debatable as to what extent,
profit centres motivate them. Sometimes, it may demotivate them.
The different arguments supporting the value of profit centre as motivational
tool can be summarized as follows:
1) A profit centre manager is perceived to have a higher status in the
organization and hence provides a psychological benefit to the division
manager. It is argued that this perceived importance motivates him to
perform better. By making the managers responsible for the profit
performance of their divisions it tried to blend their objectives with the
profit objectives of the company.
2) Profit centers tend to enhance the profit consciousness of the managers
and subordinates within the division and hence they all strive for
maximizing the profits of the division. This leads them to become
conscious about the expenses in the division. They constantly try to
evaluate every expense decision in the context of its relationship to
profits.
3) The position of being a profit centre, manager in an organization brings
in a sense of pride and belongingness, which in psychological terms
provides sustenance for the needs of self actualization and self-esteem.
Most of the organization theorists argue on these lines.
4) The freedom and authority given managers imbibe a sense of
independence and responsibility in the profit centre managers enabling
them to strive for better performance.
All these arguments are essential or inter-related and may at least partially
contribute towards better performance when combined with a realistic system
of rewards and punishments.
Several studies have been conducted in India in this regard and they have
concluded that there has been enhancement of the profit consciousness
amongst the managers as the greatest motivational contribution of profit
centers. Thus, profit centers do serve as a motivational' tool.

155
Management
Control Structure 6.11 GENUINE AND ARTIFICIAL PROFIT
CENTRES
It was earlier stated that in multi-industry, multi-business or multi-product
companies, the profit centre structure is not difficult to operate. In fact, profit
centres would be the natural choice. The divisions or units tend to be
relatively autonomous (or better called semi-autonomous) as the managers of
such units will have control over most of the input (costs) and output
(revenues) decisions. Under such conditions, the profit of the unit or division
would be a true measure of its performance. In such enterprises, the profit
centre system will come easily to them. It was also stated that within these
divisions, there may be (smaller) units which are functionally organized and
they could be treated as cost centres.

In single industry or single product companies, invariably, it is the functional

organization that prevails. The heads of the departments, e. g., manufacturing
and marketing have control over either inputs or outputs, and not both of
them. Hence, the management usually considers it more expedient to measure
either inputs or outputs, as the case may be, in monetary terms. Accordingly,
the units are known as either cost centres or revenue centres. And
accordingly, the managers are responsible for costs incurred or revenue
achieved in their responsibility centres (of course, as per standards or budgets
laid out).

But, the management, in their judgment, may like to treat such cost or
revenue centres as profit centres because it thinks that profit centre structure
has certain motivational benefits (a topic that we will discuss a little while
later) and considers it more appropriate (on account of one or the other
reason). As we discussed earlier, and depending upon the strategy chosen by
the company, the segments in certain types of organizations (i. e., diversified)
are more suited to profit decentralization than the segments in some other
type of organizations (non-diversified or companies with nominal
diversification). Yet, how the unit or sub-unit of an organization should be
treated from the management control point of view is largely a management
decision. The decision whether or not a unit should be regarded as a profit
centre is a management option/choice, notwithstanding whether the
responsibility centre manager has enough influence or control over the
activities that affect his/her “bottom line.” Such profit centres can be known
as artificial profit centres. The mechanism of transfer pricing has to be
created for such profit centres to operate.

Some of the prominent functional units that can be turned into profit centres
are discussed below.

Manufacturing: Manufacturing activity is generally treated as cost centre

and the financial performance of the responsible manager is judged against
standard costs or overhead budget. As discussed in the preceding unit, the
156 total performance of the responsible cost centre manager should be judged
taking into account his/her performance on other fronts as well, e.g., quality Profit Centres

of products, meeting of production schedules, accommodating of rush orders,

undertaking of the production of relatively difficult products, and
improvements of standards, etc..

The company, therefore, has to use different measures to judge his/her

financial performance and his/her performance on other fronts and then take
an overall view of his/her performance. Some companies consider it more
advisable to use the overall measure of profit by turning the manufacturing
unit into a profit centre. The output, which otherwise is not measured in a
cost centre, will now be measured in monetary terms by attaching a selling
price (transfer price) to it minus the estimated marketing expenses (which it
has not to incur). However, this practice has limitations, because many
factors influencing the volume and mix of sales decisions are outside the
purview of manufacturing manager. But the practice can be given a go ahead
if the management thinks that its advantages overweigh the disadvantages.

Where the manufacturing unit sells a considerable portion of its output to

outside customers, the treatment of manufacturing unit as a profit centre may
not present serious difficulties. In the absence of this, however, it would be,
what has been called, a pseudo profit centre because the revenues assigned to
it for so called sales to other unit (s) within the company are artificial.
Nevertheless, many companies, particularly in the West, treat such units as
profit centres on the belief that if they are properly designed, they will have
the same motivational benefits as genuine profit centres do. Marketing:
Marketing activity is generally a revenue centre, but it can be made into a
profit centre by charging it with the cost of products sold. With the transfer
price provided, the marketing manager can make the optimum revenue-cost
tradeoffs, and will be motivated to maximize his/her profitability. It is
important here that the transfer price is based on standard cost, and not the
actual cost of products sold; otherwise manufacturing inefficiencies, if any,
and over which the marketing manager has no control, will be carried over to
the marketing unit and will affect his/her profit performance.

The treatment of marketing unit as a profit centre would be particularly

useful where the manager is in the best position to make cost-revenue
tradeoffs. For example, different conditions may exist in different
geographical areas, e.g., branches or subsidiaries in foreign countries. In such
conditions, the local managers are in the best position to take decisions with
respect to marketing of products, sales promotion, timing of spending, choice
of media channels, training of sales persons or dealers, and selection of new
dealers, [Link] individual stores of most retail chains, individual restaurants/
outlets of fast-food chains (McDonald, Nirula, Pizza Hut, KFC, etc.)at
different places/ locations, and the individual hotels are often regarded as
profit centres.

Service and support units: There are several service and support units,
which mostly exist at the headquarters, but some of them may be located at 157
Management the divisions, especially when they tend to be large ones. The example of
Control Structure
service and support units include: maintenance, data processing, customer
service, transportation, consulting, industrial relations, etc. These units
provide services to the other units of the organization; very few of them may
provide service to the customers for which they may charge them.

Since service and support units are primarily meant for providing service or
support to other units of the organization, they do not earn revenue, and are,
therefore, fit for being treated as cost centres. But, by a decision of the
management, if they are allowed or made to charge the user departments for
the services rendered to them, they can be treated as profit centres, since with
charges levied, they earn revenues. Sometimes, such service departments
may even be allowed to sell their services to outside customers where spare
capacity is available. Similarly, the units receiving the services may be
allowed the alternative of procuring services from outside suppliers if the
latter can offer services of equal quality at the lower prices. Under these
conditions, there is an in-built motivation for the managers of such service
units to control costs so that they charge reasonable prices from the internal
users, failing which the internal users would be tempted to avail the services
from outside. Similarly, the managers of the receiving units are motivated to
make decisions about whether a request for service is worth the cost.

6.12 PERFORMANCE MEASUREMENT OF

PROFIT CENTRES
Having demarcated the boundaries for profit centres; it becomes important
and necessary to measure their performance. However, with boundaries so
set, performance measurement becomes easier and convenient. But still the
measurement of profit is not a simple task. It poses problem as the concept of
profit may not be very clear, the problem of transfer pricing has to be tackled
and the decision has to be taken regarding compensation based on evaluation.

Basic of Measurement of Performance

It is not quite easy or simple to decide the basis of measurement of

performance. However, the profit contribution by the profit centre may be
taken as basis for it. However, if current profit is taken as the basis it may be
in tune with goals of the organization which may be short-term as well as
long-term. In fact, the short term profit goals may be in consonance with the
long-term profit goals.

In this connection, one problem arises regarding question of current

profitability as compared to future growth. If we confine to current profit
only, it would be at the cost of future growth.' Similarly, the concern for
future growth can be achieved at the expense of the current profit
performance.

Another problem may arise when we devote our attention to R&D. Any
158 additional cost incurrent for R&D would certainty affect the current profit
performance. Profit Centres

Similarly, the cost for current training and development which is quite
necessary for the development of the organization ultimately has the adverse
impact on current profit performance.

The Concept of Profit

There are different concepts used related to profit, hence, that would also
pose a problem in this connection. This term may have different
connotations, such as book profit, real profit, and profit contribution. The
easiest and most acceptable concept of profit is the book profit, which is
shown by the books of account. However, when we take into account the
book profit, the problem of allocation of organizational expenses arises. It is
not easy to solve it as no method of such allocation seems to be scientific one
and that may be questionable.

The real profit may be a better basis of evaluation of performance, as the real
profit takes into account economic value of the resources consumed. For this,
valuation of resources consumed should be taken, taking into account
depreciation. In this case, also the question of allocation of common
expenses remains untackled.

This leads to choosing the third concept of profit, i.e., the profit contribution.
It implies profit contributed directly by the division. It may also be described
as `incremental profit' or the `additional profit' earned solely as a result of
operations of the division.

The Question of Expression of Profit

Another related problem is how do we express the profit in the context of

profit centres. Is it to be expressed as an absolute amount? Or as a margin on
sales? Or as a rate of return on investment? Whichever way express profit, it
has its own significance. And all the questions relating to measurement of
profit will be applicable in whatever way we express profit. .

Transfer Price and Profit Centres

The measurement of profit in a profit centre is also complicated by the

problem of transfer prices. A transfer price is a price used to measure the
value of goods/ services furnished by a profit centre to other responsibility
centres within a company. In other words, when internal exchange of goods
and services takes place between the different divisions of the firm that
requires their valuation in terms of money. It becomes quite necessary to deal
with transfer price as the profit centres as buyers and sellers should be able to
negotiate prices of such transfer independently.

Activity 3

1) What difficulties are to be sorted out before designing an evaluation

system for profit centres? 159
Management .....................................................................................................................
Control Structure
.....................................................................................................................
.....................................................................................................................
2) Can you try to enumerate the problems associated with ‘profit' and its
measurement for a division?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

Problem of Analysis of Profit Centre Results

Apart from the profit measurement and associated problems, there is also the
problem of understanding the performance itself. Usually profit performance
problem of understanding the performance itself. Usually profit centre
performance will have to be evaluated against some standards and the most
common practice is to evaluate the same against the budgets. The variances
occur as a result of the combined influence of a host of factors. Unless these
influences can be segregated and understood the major objective of control
would not be achieved. Further, reliance on the total deviation without
isolating the controllable and non-controllable aspects of the variations may
have demotivating impact on the managers.

The problem will also be different when the division is a single product or a
multi product division. However, in the case of a multi-product division the
problem may be more complex.

We shall try to analyse the variances of net income before tax for profit
centre. We use the data of Ibid Apparel presented in Table 6.3 and 6.4 for this
purpose. For the sake of simplicity, we have grouped the products into major
groups and we will use the average data for each group as the per unit
information

Table 6.3 : Ibis Apparels Master Budget Sales and Expense Data for
Period 1 (in 000) Products
Products
Under garments Outer garments Master
Per Unit Total Per Unit Total Budget
Sales in Units 7,000 8,000 15,000
Sales Revenue Rs.10.00 Rs.70,000 Rs.40.00 Rs.3,20,000 Rs.3,90,000
Variable expenses
Manufacturing 400 28,000 15.00 1,20,000 1,48,000
Marketing 2.00 14,000 8.00 64,000 78,000
Total Variable expenses Rs.6.00 Rs.42,000 Rs. 23.00 Rs.1,84,000 Rs.2,26,00
Contribution margin Rs.4.00 Rs.28,000 Rs.17.00 Rs.1,36,000 Rs.1,64,000
160
Fixed expenses Profit Centres
Manufacturing Rs.60,000
Marketing Rs.75,000
Administration 14,000
Total Rs.1,49,000
Net profit before taxes 15,000

Table 6.4: Ibis Apparels Actual Sales and Expense Data for Period 1

Products

Undergarments Outer-garments Actual

Total
Per Unit Total Per Unit Total

Sales in Units 10.000 5,000 15,000

Sales Revenue Rs.9.00 Rs.90,000 Rs.50.00 Rs.2,50,000 Rs.3,40,000

Variable expenses

Manufacturing 3,50 35,000 30.00 1,00,000 1,35,000

Marketing 1.50 15,000 10.00 50,000 65,000

Total Variable 5.00 50,000 30.00 1,50,000 2,00,000

expenses

Contribution margin 4.00 40,000 20.00 1,00,000 1,40,000

Fixed expenses
Manufacturing 50,000

Marketing 65,000

Administration 15,000

Total 1,30,000

Net profit before 10,000

taxes

On comparing the budget and actuals presented in Table 6.1 & 6.2 we find
that the profit before tax is down by Rs. 5,000 from the budgeted figure. Let
us disaggregate the information and see the actual influences so as to
understand the performance of the profit center. As a first step towards this
we try to construct the flexible budget for the division. Table 6.3 presents the
flexible budget calculations.

161
Management Table 6.5: Ibis Apparels Calculation of Flexible Budget for Period
Control Structure
Sales Revenue (actual units sold x budgeted selling price)

Undergarments 10,000 x Rs. 10.00 = Rs. 1,00,000

Outer garments 5,000 x 40,00 = 2,00,000

Total 15,000 3,00,000

Variable expenses

Undergarments (actual units sold x budgeted variable expense)

Manufacturing 10,000 x Rs. 4.00 = Rs. 40,000

Marketing 10,000 x Rs. 2,00 = 20,000

Total Rs. 60,000

Outer garments

Manufacturing 5,000 x Rs. 15.00 = Rs. 75,000

Marketing 5,000 x 8,00 = 40.000

Total 15,000 Rs. 1,15,000

Total Manufacturing Rs. 1,15,000

Variable expenses

Total Marketing Rs. 60,000

variable Expenses

Total Rs. 1,75,000

Table 6.6: Ibis Apparels Calculation of Volume-mix and Expense-price

Variances for period I

1 2 3 (1-2) (2-3)
Master Flexible Actual Volume & Expense &
Budget Budget Mix price
Sales units 15,000 15,000 15,000 0 0
Sales
Revenues (Rs. `000) 390 300 340 90 U 40F
Variable Expenses (Rs.
`000)
Manufacturing 148 115 135 33 F 20 U
Marketing 78 60 65 18 F 5U
162
Total Variable Expenses 226 175 200 51 F 25 U Profit Centres

Contribution Margin 164 125 140 39 U 15 F

Fixed Expenses (Rs.
`000)
Manufacturing 60 60 50 0 10 F
Marketing 75 75 65 0 10 F
Administration 14 lit. I 1U
Total fixed expenses 149 149 130 19 F
Profit before taxes ('000) 15 (24) 10 39 U 34 F
Notes
1) Sales Volume Variance = Master budget average contribution margin per unit x (Actual
sales units - Master budget sales units) =(Rs. 1,64,000/15,000) x (15,000 - 15,000) = 0,
2) Sales mix variance = (Flexible budget average contribution per unit - Master budget
average contribution per unit) x Actual sales unit = [ (Rs.1,25,000/ 15,000) -
(1;64,000/15,000) ] x 15,000 = Rs. 39,000 U.

Sales volume and Mix Variances

From Table 6.6 it is easy to understand the actual performance and see how
the decline in profit after tax of Rs. 5,000 has resulted. We can see that the
total sales volume of 15,000 has not change and hence no loss is attributable
to volume variance. However, the sales mix does change and the drop in sales
of high contribution outer garments results in a combined loss of Rs. 39,000,
despite an increasing in sales of low contribution undergarments. That is, the
company has lost a contribution of Rs. 51,000 on outer garments and gained
a contribution of Rs. 12,000 on undergarments, thus incurring a loss of Rs.
39,000 on account of sale mix change

Master budget contribution Undergarments Outer

garments

Margin per unit Rs. 4.00 Rs. 17.00

Budgeted sales units 7,000 8,000

Sales mix % 46.67 53.33

Actual sales 10,000 5,000

Actual sales mix % 66.67 33.33

Price and Expense Variances

The Rs. 40,000 favourable price variance in Table 5.4 arises from the fact
that the average actual sales price exceeded the average flexible budget sales
price. This can be disaggregated by products as follows:
Undergarments (Rs. 9.00 - 10,000 = Rs. 10,000 U
Outer garments (Rs. 50.00 - 40,000 = Rs. 50,000 F
Rs. 40,000 F
163
Management The total expense variance is Rs. 34,000 favourable which can be
Control Structure
disaggregated as follows:

Manufacturing variable Rs. 20,000 U

Manufacturing fixed 10,000 F Rs. 10,000 UF

Marketing variable Rs. 5,000 U

Marketing fixed 10,000 F Rs. 5,000 F

Administration 1,000 U,
Total Rs. 6,000 UF

Now we have a clear idea as to which segments of the business have

contributed towards gains and which segments contributed towards losses.
This information will help the profit center management and the top
management to tackle the situation better.
Summary of Variances
Sales Mix variance Rs. 39,000 UF
Sales Price variance 40,000 F
Expenses variances 6,000 UF
Total Rs. 5,000 UF

This analysis explains the actual performance of the profit center.

In measuring the performance of a profit centre, we must make a distinction

between what is called managerial performance and economic performance.
While managerial performance focuses on how well the manager is doing
(i.e., how well s/he is planning, controlling and coordinating the day-to-day
activities of the profit centre) and is evaluated in terms of his/her financial
performance plus the other factors agreed upon in advance. Financial
performance is one of the factors in that process. Important Economic
performance focuses on how well the profit centre is doing as an economic
entity.

If the distinction is not maintained, the performance appraisal may get

blurred or distorted. The signals emanating from the two measures may be
quite different. For example, the management performance report of a store
may show that profit centre manager is doing an excellent job under the given
circumstances. But the economic or financial performance report may
indicate that, because of the competitive conditions in the area and other local
factors, the store is a losing proposition, and perhaps needs to be wound
up/closed.

Types of Profitability Measures: Concepts of Profit

How the managerial performance will be measured depends upon the

performance package (package of the criteria) developed by the corporate
164
management which may be used with a certain fixed periodicity, say every Profit Centres

six months or at the end of each financial year. Financial performance may be
measured more frequently, say at the end of each quarter or at the end of
every six months or at the end of each year (depending upon the practice laid
down by the management) by using one of the concepts of profitability as
follows:

• Contribution Margin
• Direct Profit
• Controllable Profit
• Net Income.

How profitability is arrived at by using different types of profitability

measures is demonstrated in Table 6.7. We will explain all these concepts
one by one.

Table6.7: Profit Centre Statement (Methods used for determining

Profitability)

Amount
Rs.
Revenue 10,000
Cost of sales 6,000
Variable expenses 1,800

Contribution margin 2,200

Fixed expenses incurred in the profit centre 900
Direct profit 1,300
Controllable corporate charges 100
Controllable profit 1,200
Other corporate allocations 200
Income before income taxes 1,000
Taxes 400
Net income 600

Contribution margin: Contribution margin in other words is the variable

profit, that is, the difference between revenue and variable cost. The
argument in favour of contribution margin as a measure of financial
performance of profit centre manager is that fixed costs are not controllable
by the manager. The signal that goes that the manager should focus his/her
attention on increasing or widening this gap/difference.

The other side of the argument is that some fixed costs are entirely
controllable at the profit centre level while some others are partially
controllable. The profit centre manager may have some influence in
controlling the fixed costs even though that may be in the long-run. It is 165
Management because of this reason that some firms like to show the fixed costs in the
Control Structure
performance reports (in accordance with the figures agreed upon-at the
beginning of the budget exercise) so that the manager may feel that s/he has
some responsibility in this respect. Further, even if an expense, such as
administrative salaries cannot be changed in the short-run, the profit centre
manager is in a position to control the efficiency and productivity of the
employees.

Direct profit: This measure is arrived at by deducting the fixed costs

incurred in the profit centre whether they are controllable or not. Fixed costs
would include costs directly traced to the profit centre. But expenses that
cannot be directly traced to the profit centre are not allocated, e.g., costs
incurred at the headquarters.

Controllable profit: If controllable corporate office costs are deducted from

the direct profit, the figure so arrived at is known as controllable profit. The
costs incurred at the corporate office can be divided into two categories:
controllable and non controllable. The former includes expenses that are
controllable at least to a degree by the profit centre manager (e.g., MIS costs)
or on which s/he can exercise some influence.

Income before taxes: This measure is controllable profit minus other

corporate allocations made on some rational basis (i.e., all the corporate
overheads are allocated). This measure goes against the concept of
controllability which is the cornerstone of Responsibility Accounting. The
costs incurred by corporate staff departments, such as finance and
accounting, human resource management, etc. are not controllable by profit
centre managers. Therefore, they should not be held accountable for what
they do not or cannot control. Further, it may be difficult to work out a
rational/acceptable method of allocating costs of corporate staff services
which would reflect the costs caused by a particular profit centre.

However, arguments have also been made in defense of this measure. It has
been stated that such allocations make the profit centre managers conscious
of such costs. Hence, if the profit centre managers feel that costs are being
excessively incurred, they can make suggestions to cut costs or bring the
costs to more realistic levels. Further, it has been argued that this measure
will make/render the segmental performance comparable to the performance
of a competitor who has also to pay for such services. As a further argument,
it has been stated that this measure gives a message that profit centre has not
earned a profit unless it recovers all costs, including a share of allocated
corporate overheads. So, while making decisions about pricing, product mix,
etc., profit centre managers will keep in mind that they must recover their
share of the corporate overheads. The top management wants to send a
message to the managers that without recovering the corporate overheads, the
company would not be viable in the long-run.

Net income (income after taxes): The figure of net income is arrived at after
166
deducting the portion of taxes from the preceding measure. This measure Profit Centres

falls in line with the measure adopted by the company as a whole. However,
there are arguments for and against using this measure. The arguments that
are put forward against this measure include

(i) Income tax is often a constant percentage of pre-tax income, hence no

advantage is gained by allocating taxes;

(ii) (ii) many decisions that have an impact on income taxes are made at
the headquarters, and as such profit centre managers have no control
on them.

Further, some divisions of the company may be entitled to fiscal incentives

under tax and other laws; with the result that effective tax rate is lowered.
This may be particularly true in respect of foreign subsidiaries/ business units
with foreign operations. Hence, even if taxes are allocated, this fact should be
kept in mind, otherwise it may cause resentment among the concerned
divisions.

Those who argue in favour of this method say that profit centre managers
may be motivated to influence income taxes by their decisions on acquiring
or disposing of plant, machinery and equipment, buy or lease choices and
other ways by which taxable income can be minimized.

The performance of a profit centre is appraised by comparing actual results

with one of the measure chosen from above measures based on budgeted
amounts. In addition, the date on competitors and the industry averages
provide a good cross check on the appropriateness of the budget.

The rule in regard to timing of revenue recognition has to be laid down, that
is, should revenues be recognized at the time the order is received, or at the
time the order is shipped, or at the time cash is received.

At times, there may be situations which give rise to what is called common
revenue in the generation of which two or more profit centres may participate
in the sales efforts. Ideally, the revenue should be credited to the participating
profit centres in proportion to the effort made. But practical problems may
defy such allocations. Therefore, many companies do not give much attention
to the common revenues, because the identification of precise responsibility
or contribution in revenue generation is often too complicated to be practical.
However, where such situations arise quite frequently, some basis or method,
even if it is rough or tentative, has to be evolved and communicated.

Example6.1

Bharat Company has four operating divisions. The managers of these

divisions are evaluated on their divisional net income before taxes, a figure
that includes an allocation of corporate overhead proportional to each
Division's sales. The operating statement for the first quarter of 2021 appears
below:
167
Management Particulars DIVISION(Rs. in lakhs)
Control Structure
Basic Electronic Board Imported Total
toys toys games Toys
Net Sales 2,000 600 900 1,300 4,800
Unit and batch 1,050 300 380 500 2,230
related cost
Division capacity- 250 75 80 130 535
related costs
Division margin 700 225 440 670 2,035
Allocated corporate 400 120 180 260 960
expenses
Net Income before 300 105 260 410 1,075
taxes

The manager of the “Basic Toys” Division is upset that his profitability is
about the same as that of “Imported Toys” even though his sales are much
higher. The manager knows that he is carrying one line of products with very
low profitably. He was planning to replace this line of business as soon as
more profitable product opportunities became available but has retained it
until now because the line was still marginally profitable and utilized
facilities that would otherwise be idle. However, the manager also observed
that the sales from this product line are attracting a fair amount of corporate
overhead, which is allocated at the rate of 20% of net sales, and maybe the
line is already unprofitable for him.

This low margin line of products had the following characteristics for the
quarter:

Net Sales 800

Unit and batch related costs 600
Division capacity-related costs 100
Division margin 100

Thus the product line accounted for 40% of the divisional sales but less than
15% of the divisional profit.

Required

1. Prepare the operating statement for Bharat Company for the second
quarter of 2021, assuming that sales and operating results are identical to
the first quarter except that the manager of “Basic Toys” drops the low
margin product entirely from his product group. Is the Division manager
better off from this action? Is the Bharat Company better off from this
action?
2. Suggest changes in the Bharat Company's Divisional reporting and
evaluation system to improve local decision-making incentives in the
firm's best interests.
168
Solution: Profit Centres

1. Currently, the product that is intended to be dropped has a contribution

of Rs.100,000. If the Division drops the product, then the Income
Statement of Bharat Company will be as follows:
Current After dropping
the product
Net Sales 4,800 4,000
Unit and batch related cost 2,230 1,630
Division capacity-related costs 535 435
Margin 2,035 1,935
Allocated corporate expenses 960 960
Net Income before taxes 1,075 975

The income statement of the “Basic Toys” Division will be as follows:

Current After dropping

the product
Net Sales 2,000 1,200
Unit and batch related cost 1,050 450**
Division capacity-related costs 250 150**
Division margin 700 600
Allocated corporate expenses 400 240
Net income before taxes 300 360
**After deducting the costs relating to the product to be dropped.

Therefore, the “Basic Toys” Division will decide to drop the product.
However, the margin of the Division has reduced from 700 to 600. The
income has increased because the allocated corporate expenses have been
reduced. However, since these expenses are only allocated, these are
unavoidable corporate expenses, so the organization's total costs have not
decreased. Only the allocation has changed, thereby increasing the reported
income of a Division.

If “Basic Toys” drops the product, the organization's income will go down by
Rs.100,000, as is evident from the income statement of Bharat Company.

2. The current reporting may be inappropriate because expenses are

allocated as a percentage of sales. This means the higher the sales a
Division reports, the more the overhead allocation for the Division. This
will prompt Divisions to report lower sales figures to reduce the
allocation.

Therefore, the allocation of corporate expenses should be done on a rational

basis. They could use Activity Based Costing to allocate the common costs.
169
Management Measuring Profitability:
Control Structure
Suppose an organization has five profit centers A, B, C, D, and E; how can it
be reliably established as to which is the most efficient profit center? The
performance of a profit center is usually judged by the income generated by
the profit center. However, income or profit can be defined at several levels.
Profit could begin with a contribution, the revenue net of variable expenses.
We could also define profit as the direct profit earned in the Division, the
contribution net of the fixed costs incurred.
Similarly, the Divisions also earn controllable profit and profit before taxes.
We can compare the performance of various profit centers using this Income
Statement. However, since there are several income levels, we need to
understand how to read this income statement and what level of income
should be compared to assess the performance of a profit center. The
following is the Income Statement of a profit center.

Income Statement of Profit Center

Revenue
Less: Cost of Goods Sold
(Variable costs)
Contribution Margin
Less: Fixed expenses incurred in the profit center
Direct Profit
Less: Controllable Corporate Charges
Controllable Profit
Less: Other Corporate Allocations
Income before Taxes
Less: Taxes
Income after taxes
Example 6.2
The following is the Income Statement of SBUs of Hindustan Company Ltd.
The income statement forms the basis for the incentive plan for the head of
the SBUs. There is some thinking about the ideal measure for rewarding the
SBU heads.
Particulars SBU1 SBU2 SBU3
(All figures in Rs. 000's)
Sales 12,000 14,000 18,000
Variable Cost 5,000 6,000 8,000
Contribution 7,000 8,000 10,000
Direct fixed cost 1000 3,000 6,000
Direct Profit 6,000 5,000 4,000
Controllable corporate charges 1,500 500 600
170
Required: Controllable Profit 4,500 5,500 Profit Centres
3,400
Rank the profit centers Other corporate allocations 600 1,200 1,200
as per the performance Income before taxes 3,900 4,300 2,200
on each parameter
indicated in bold.

Solution:

Particulars SBU1 SBU2 SBU3

(All figures in Rs. 000's)
Sales 12,000 14,000 18,000
Variable Cost 5,000 6,000 8,000
Contribution 7,000 8,000 10,000
Rank 3 2 1
Direct fixed cost 1000 3,000 6,000
Direct Profit 6,000 5,000 4,000
Rank 1 2 3
Controllable corporate charges 1,500 500 600
Controllable Profit 4,500 5,500 3,400
Rank 2 1 3
Other corporate allocations 600 1,200 1,200
Income before taxes 3,900 4,300 2,200
Rank 2 1 3
As evident from the solution above, each SBUs gets ranked differently
according to each parameter.
Example 6.3
The following is the Income Statement of SBUs of M ltd that forms the basis
for the incentive plan for the head of the SBUs. There is some thinking about
the ideal measure for rewarding the SBU heads.
Particulars SBU1 SBU2 SBU3 SBU4
(All figures in Rs.’000)
Sales 6,000 7,000 9,000 8,000
Variable Cost 2,500 3,500 4,000 3,500
Contribution 3,500 3,500 5,000 4,500
Direct fixed cost 900 1,000 2,100 1,400
Direct Profit 2,600 2,500 2,900 3,100
Controllable corporate 400 600 1,100 2,000
charges**
Controllable Profit 2,200 1,900 1,800 1,100
171
Management Other corporate 600 200 600 600
Control Structure
allocations***
Income before taxes 1,600 1,700 1,200 500
** Of the controllable corporate charges, 5% is allocated to sales turnover since the
headquarter feels that sales related expenses account for about 5% of the costs incurred at the
Headquarter level
*** Other Corporate Allocations consist of corporate charges allocated to SBUs. Rural
branches get a lesser share of these allocations because several initiatives of M Ltd. are
urban-based. Hence SBU 2 is charged a lesser percentage of the corporate allocations.

Required:

a. You are required to advise the management on which of the above

measures (highlighted in the income statement in bold) you consider
appropriate to judge the efficiency of the SBUs and attribute relevant
reasons for the same.

b. Should Income taxes be considered in the calculations above? Why/Why

not?

Solution:

a. The purpose of a profit center is the generation of profit.

Sales cannot be a reliable measure to evaluate a profit center since it is

the function of a revenue center to maximize sales. The scope of a
revenue center is limited compared to that of a profit center.

Direct profit is calculated without accounting for expenses incurred by

the Corporate Headquarters. So it is not an appropriate measure.

Controllable profit excludes other expenses incurred at Headquarters.

Suppose profit centers are not made accountable for these costs.
Eventually, these costs will not be controlled at any level, and there will
be no accountability for expenses incurred in this head.

Income before Taxes is the better measure of income evaluation for

Divisions since it makes managers accountable for all the costs incurred,
whether at the Divisional level or the headquarters level. Therefore,
Divisions can be reliably evaluated on the income they earn before taxes.

b. Taxes should not be considered because taxes are a corporate function

and are usually levied on the entire organization's profits. Also, some
Divisions may operate in tax-free zones because of which it may become
difficult to evaluate the after-tax profits of Divisions.

Analysis of Profit Center Result Performance appraisal:

Profit centers play a crucial role in determining the most profitable and least
profitable units in an organization. This helps to make managerial decisions
and comparisons among various units in the organization.

Analysis of profit centers helps the management allocate future resources or

172
determine whether a production unit/service unit should be continued. Profit Centres

However, one must keep in mind that while profit center analysis helps us
understand the past performance, this does throw any insight into future
performance. Based on past performance, resource allocation is done for the
future.

Can Expense centers be converted to profit centers?

Decentralization facilitates decision-making across the organization. In other

words, it does not centralize power at the top. However, management is
ultimately responsible for ensuring the optimum relation between input and
output. If responsibility is causal and direct, the measurement becomes
relatively easier. Not all units are capable of being evaluated on the same
basis. Some units do not generate any revenue; they only incur costs
supporting some necessary function. Other units that deliver goods and
services have the potential to generate profits sometime in the future. Can
Divisions that operate as cost or expense centers be converted into profit
centers?

Cost centers may provide services that could generate profits if offered
outside the organization. Companies may want to convert their cost centers to
profit centers since that may improve the efficiency of a Division and help
the overall growth of the business. Sometimes it may also help them to gain a
competitive advantage over competitors.

Let us take an example of Information Technology (IT) services. Usually, the

IT Division is considered an expense center for the company. If the IT
department provides service to its internal customers and the cost of this
Division is borne by all the Divisions using IT service, then IT Division
would operate as an expense center. However, if this Division starts charging
other Divisions for services rendered, it can be evaluated as a profit center.
Also IT department can sell its services to outside customers, which will
generate revenue for the company.

Let us consider another example of a hospital. Flower Hospital is a reputed

hospital in the city and has several famous surgeons visiting the Hospital to
perform surgeries and in-house doctors. The Hospital has state-of-the-art
pathological testing, surgery, and recovery post-surgery facilities. The
Hospital was reputed for its humane care, and the success rate of surgeries
and the recovery rates post-surgery were very high. However, the Hospital
was highly renowned for its testing services of the pathology department.
There were several tests for which facilities were not available anywhere else
in the city.

Flower Hospital, therefore, decided to operate the pathology department as a

profit center with operational autonomy. It has contributed to the Hospital's
bottom line and helped the Division fund newer equipment and technology.

From the discussion above, it follows that there are two essential criteria for
173
Management an expense center to be converted into a profit center:
Control Structure
1. The output should be measurable- in the example above, the IT Division
should be able to quantify the service rendered in monetary terms.
2. The Division should also be free to sell its products or services outside
the organization.

The profit center approach allows for expanding revenue and profit and
building the leverage base.

Performance Related Compensation

If compensation is related to performance of the divisional managers, that
certainly motivates them to put in their best. The compensation linked with
performance should provide sufficient incentives to such managers so that
they may be duly motivated to maximum contribution to the overall profits.

It is also necessary that the measurement of profit of the centres should be

undertaken objectively. Any objective measurement, linked with the effective
system of adequate compensation, would be an important motivational factor.

The amount of and nature of compensation should be in the overall context of

the organization. For that it is essential that the evaluation is undertaken at
collective level and the incentives, through compensation, are quite realistic
so as to motivate the divisional managers.

6.13 TARGET PROFIT, BUDGETING AND

REPORTS
In this section we talk about some aspects and issues relating to target profit
setting, ' budgeting process and performance reports of profit centres.

Target Profit

Once it has been decided that the financial performance of a unit will be
measured on a profit centre basis, it becomes a regular periodical (half-yearly
or yearly, whatever is decided) exercise to determine the target profit. In
progressive business enterprises which believe and practice participative
management, target profits are decided upon after mutual discussions
between the top management and the profit centre managers. While the
determination of target profit of a profit centre is parallel in concept to the
determination of target profit (or return) for the company as a whole, it is
usually different in practice. The profit centre is usually a division or segment
(or a part) of a larger company, and there is seldom capital stock outstanding
or a stock market to determine target profit.

After the target profit has been established, the next step is detailed planning
by profit centre management to find the means by which the target profits are
to be achieved.

174
 Profit Centres

Profit Centre Budgeting

The means for achieving target profits may involve a number of action plans
and new initiatives like increased marketing or research budgets, higher sales
volumes, penetration into new geographic areas, the adding or dropping of
products, and other activities which would be the responsibility of the profit
centre managers. All these activities are translated into a feasible plan, whose
financial impact is expressed as a projected or budgeted income statement
and whose net outcome is the target profit agreed upon.

After the budget, expressed as income statement, has been prepared by the
profit centre manager, the next step is to present the same to the top
management or their appointed committee in a comparative form, comparing
the projected statement with actual income statement of the most recent year.
The profit centre management should be prepared to explain the differences,
both favourable and unfavourable, which appear in the comparative
statement.

If the top management is convinced that the plan presented by the profit
centre management is feasible and is very likely to achieve the profit target,
the projected income statement is approved, which also signifies the
commitment of the corporate management to provide the centre management
with the resources necessary to carry out the plan.

An illustrative budget of Profit Centre AZ of Karewel Company for 2021-22

is presented in Table [Link] profit centre produces molded metal and plastic
parts on large orders to the specifications of other manufacturing companies
for incorporation into their products. For the profit centre, the recent years
have been good, and the centre could comfortably spend on marketing
research and human resource development while still maintaining the
traditional profit margins as percentage of sales. During these years relatively
small amounts had been spent on product development but the customers
have been asking for new (changed) products as they have developed new
applications.

The budget for 2020-21 had been approved after considerable negotiations
with corporate management.

Table 6.4: Income Budget for submission to Top Management

Karewel Company
Profit Centre AZ
(Rs. in thousands)
2020-21 2021-22
Actual Budget
Revenues
Metal products 2,999 3,440
175
Management Plastic products 1.169 1.344
Control Structure
Total revenue 4,168 4,790
Expenses
Cost of goods sold:
Metal products 2,099 2,371
Plastic products 760 941
Marketing ;
Salaries and commissions 265 300
Advertising 55 60
Research 70 90
Administration:
Salaries 165 162
Human resource development 60 75
Facilities 63 66

Product research 230 175

Total expenses 3,767 4,240
Profit centre contribution to net income 401 550

Problems of Profit Centre Reporting

In a profit centre, as was pointed out earlier, the management, as compared to

a cost centre or revenue centre, has more options on how to combine expense
and revenue outcomes to produce the desired target profit. Some difficulties
are created by the fact that top management reserves certain decisions for
itself.

Revenue Difficulties

Two major revenue problems may arise from controllability of revenue and
transfer prices.

Control of revenue: It is generally expected that the profit centre manager

has the authority to adjust prices with the resultant volume changes, and
spend additional sums on advertising, sales commissions, product quality,
product design, etc. in the hope that the additional expense will be offset by
additional revenue. But, if the profit centre manager lacks the authority to
make the tradeoffs decisions, the use of the profit centre to evaluate financial
performance is undermined to some degree. If authority to control just a few
of these factors is reserved for the top management, the presumption is that
the benefits of applying the profit centre concept outweigh the potential
disadvantages.

Transfer pricing problem: Transfer pricing problem would exist when a

profit centre is required to sell some or all of its products to other divisions of
the company. The selling price and the volume of operations then at least
176
partially become dependent on the actions of other divisions, and the Profit Centres

concerned divisions lose some of their autonomy. If the buying and selling
divisions have the option and are free to buy or sell, then the problem of
dependence is averted.

Transfer prices present significant difficulties in two circumstances: (i) where

no competitive market exists for the product; and (ii) if top management does
not permit the selling division to refuse an order from buying division or does
not permit the buying division to buy from outside supplier. It is natural that
the buying division will seek the lowest possible price for the product it
purchases from another unit/division, since it becomes a part of the goods
sold reflected in the buying division’s report of financial performance. The
selling division will, which is a profit centre too, will seek the highest price,
since the higher price results in higher total revenue on the selling division’s
report of financial performance.

Expense difficulties

The major expense problems in profit centre reporting are related to the
controllability of costs by profit centre managers. There are two major
problem areas: sunk cost items, and centralized services.

Sunk Cost items: A problem of controllability is created when certain

expense levels arise from decisions made in the past and which are
uneconomic to reverse. An example is the cost of a plant built a number of
years ago. The depreciation, insurance, production methods, production
capacities, etc. depend upon the nature and cost of the plant about which the
decision was taken by the previous manager, and over which the present
manager has no control but is bound by it. Past decisions in this respect thus
constrain his/her freedom to act.

Centralized services: In the interest of the company as a whole, certain

support services, as we examined earlier, are centralized for the use of the
divisions/profit centres. But, again, such an arrangement constrains the
freedom and choice of the profit centre managers.

In addition, there are certain items which are generally considered to be the
prerogative of the central management; for example, collective bargaining
agreements with a national union covering all company employees. The
divisions/profit centres have no option but to abide by union contract
decision. Similarly, some advertising of overall nature or for corporate image
building is also undertaken by the central management over which centre
managers have not much control.

Analysis of Profit Centre Results

There are three basic concerns when analysing profit centre results.

The first concern is whether the manager has achieved the target profit. When
there is a significant variation in the actual profit and the target profit, the
177
Management management may like to match actual and budgeted revenues and expenses
Control Structure
on an item-by-item basis.

The second concern relates to whether the manager deviated from the plan,
and if s/he did, then whether it was consistent with the attainment of
corporate and profit centre objectives. The third concern is to examine the
nature of actions taken by the profit centre manager. Did s/he do anything
which will have a negative or adverse impact and will thus weaken the profit
centre’s or the company’s position in the years beyond the budget period. In
other words, the corporate management would like to check whether the
centre manager took any actions which are likely to harm/hurt the long term
interests of the centre or company as a whole.

Table 6.9 presents the results of the Profit Centre AZ of Karewel Company
for 2020-21 which also shows the budgeted data and the variances. We
suggest that you analyse the results yourself by offering all possible
explanations for the variances, keeping in mind the three concerns that have
been discussed above.

Table 6.9: Budgeted and Actual Contribution to Net Income, 2020-21

Karewel Company Profit Centre AZ

(Rs. in thousands)
Budgeted Actual Variance
Revenue
Metal products 2,630 2,679 49
Plastic products 1,015 974 (41)
Total revenue 3,645 3,653 8
Expenses
Cost of goods sold:
Metal products 1,840 1,875 (35)
Plastic products 589 584 5
Marketing
Salaries and commissions 236 237 (1)
Advertising 56 54 2
Research 115 120 (5)
Administration
Salaries 164 170 (6)
Human resource development 100 90 10
Facilities 59 59 -
Product research 65 62 3
Total expenses 3,124 3,251 (27)
Profit centre contribution to 421 402 (19)
Net Income
178
6.14 PERFORMANCEAPPRAISAL Profit Centres

In performance appraisal, as was noted earlier, the management must

distinguish between performance of the manager and performance of the unit
as an economic activity.

The performance of the manager, in the first instance, means his/her financial
performance, which would be based on a comparison between the actual
profits earned by his/her profit centre against the agreed target profit. Here
the fundamental rule in accordance with the concept of Responsibility
Accounting is that managers should be measured against those items that they
can influence. Hence, the basis of comparison usually should be either the
direct profit or controllable profit. In the case of foreign branches,
subsidiaries or operations, the influence of currency fluctuations should be
eliminated. As discussed in the previous unit, degrees of influence vary.
There are always items over which a manager may exercise some influence,
but little real control. In view of this, therefore, variance analysis is always
important in evaluating managerial performance, and here, significance of the
variance has to be judged.

In appraising the profit centre as an economic entity, the measure generally

chosen would be in line with the measure adopted for the company as a
whole. Here, net income measure will be found more suitable, because the
company as a whole is judged by the external stakeholders on the basis of
this yardstick. The primary purpose in appraising a profit centre as an
economic entity is to judge whether the profitability of the profit centre is
worth the investment made (in it in terms of return on investment).

Top management’s interest in economic performance stems from its

responsibility to allocate resources profitably. If profit centre profit (or
return) is inadequate in terms of the management’s objectives, then ways
should be sought to improve profitability. If the efforts still fail, then
theoretically at least, the profit centre activities should be liquidated and the
resources should be diverted to other attractive uses. To reiterate what was
said at the beginning of this section, the management may be fully satisfied
with the performance of a profit centre manager, yet fully dissatisfied with
the division/ profit centre as an economic entity, or vice versa.

As discussed earlier, the financial performance of a profit centre is measured

in terms of profit. Since profit cannot capture all the economic consequences
of the activities of a decentralized unit in given period, the performance
appraisal of the profit centre manager has to be broad based. Only then could
one judge how s/he has performed the total job. The non-monetary measures
have to be supplemented to the profit measure. Profit as a sole measure of
performance for profit centre managers has its obvious limitations. Probably,
the most serious concern with narrowly focused attention on periodic profit
reports is that managers will take actions that sacrifice long-term profitability
for short-term reported profits. There are a number of ways this could occur, 179
Management such as lowering of quality controls, in adequate maintenance, insufficient
Control Structure
spending on R&D and employee training, and lack of attention to customer
relations and employee morale. You are well aware now that all such actions
lead to what is called dysfunctional behaviour.

To balance off an exclusive attention on reported profits, some companies

have developed performance appraisal systems in which profitability is only
one component. Profit centre managers are given (and agreed to by them)
goals to meet in regard to human resources, distribution, technology, product
quality, development of new products, exploration of new markets, etc..

Needless to say that these are the key areas which are crucial to the long term
success of the profit centre/division, and these are probably the areas where
greatest improvement can take place. The manager then would be evaluated
on whether the targeted goals were also achieved in these key areas. At first
blush, the goals in these various respects may seem to be an intrusion on the
decision making authority of the profit centre managers. But this is necessary
because of the inadequacy of profit as a measure of performance, in so far as
the long-term consequences may not be visible until the damage has occurred
in future. Loss of customer good will due to weak quality of workforce, etc.
would take time to manifest them, and by that time it might be too late to
control the damage.

What broad-based systems of performance appraisal the companies have

developed, or they can use, will be more fully discussed in Unit 7 on
Investment Centres, as the approach and points of discussion are common
both for profit and investment centers.

Whenever the manager of profit centre is evaluated on more than one

dimension, the problem of weighing the various dimensions into an overall
measure arises. While some companies may do so, some others may prefer
not to have an explicit formula that might encourage managers to trade off
performance along one dimension against performance on another. If the
performance appraisal system recognizes multiple performance measures or
factors, it would signal the manager that each one of the factors is considers
important and that less than satisfactory performance on any discouraged
from neglecting any of the measured factors. if the managers face any
difficulty arising from a conflict between two or more of the multiple criteria
and which they have pointed out to the management, then it is the
responsibility of the that the management remains constantly vigilant to
ensure that long- term profitability is not sacrificed by actions that maximize
short-term reported profits.

6.15 SUMMARY
Profit centres are organizational units for which some measure of profit is
determined, periodically.
The autonomy of profit centre managers depends upon philosophy and style
180
of corporate management, and is related to the responsibility structure, Profit Centres

management process and policies, and the extent of custody of resources that
have been entrusted to the managers, and the reward system.
Profit decentralization is closely linked with the strategy of diversification
and the accompanying diversity in business activities.
Profit centres, based on the concept of Responsibility Accounting, come into
existence as a result of the decision of the corporate management. To be
efficient, they must meet certain requirements.
Profit decentralization can lead to several benefits for the organization like
better understanding about ultimate profit objectives, better morale and
motivation, and provide a training ground for middle level managers for
sharing greater responsibility in future.
There are several difficulties associated with profit decentralization like
frequent frictions, possibility of dysfunctional decision making, and
unhealthy competition.
Difficulties, however, can be overcome through proper planning and design
of the profit centre system, rational transfer pricing, and emphasis on long-
term profitability.
Profit centre concept is highly popular in the USA, and even in India and
other countries.
The prominent reason for their widespread prevalence is the motivational
value that they are considered to carry.
Organizational units like manufacturing, marketing, support and service
departments, which are normally candidates for cost centres or revenue
centres, can be made into profit centre by a decision of management.
There are several methods of determining profitability of profit centres, viz.,
Contribution Margin, Direct Profit, Controllable Profit, and Net Income.
Target profits for profit centres are set up and agreed upon with the beginning
of the budgetary exercise and planning activity. The action plans for
achieving targets may require additional resources that have to be provided
for in the budgets.
Certain difficulties relating to reporting of profit centre performance have to
be resolved.
The analysis of profit centre results should take place in the light of certain
concerns about which the management should be aware of.
Performance appraisal of profit centre managers should be broad-based, and
profit should be taken as one of the criteria, though an important one.

6.16 KEYWORDS
Artificial profit centre : A profit centre created by corporate management
where the manager does not have real control over either inputs or outputs.
181
Management Corporate philosophy: The fundamental values, beliefs and ideology of top
Control Structure
managers reflected in their vision and organizational mission.

Dysfunctionality: Sub-optimal decisions arising when personal goals of

managers do not match with those of the organization.

Genuine profit centre: Profit centre where most of the input and output
decisions are within the control of the profit centre manager.

Managerial autonomy: The domain of freedom that the profit centre

manager has in decision making in relation to the factors that affect his/her
performance.

Profit centre: An organizational unit for which some measure of profit is

determined periodically.

Profit decentralization: The process of assigning overall corporate

responsibility' for profit and delegation of authority to various organizational
units that gives rise to the creation of profit centres.

Target profit: Profit targeted for a profit centre which has been mutually
agreed upon and for which the corporate management is committed to
provide needed resources.

Transfer price: The price (arrived at through one of the several methods) at
which goods and services are transferred from segment/profit centre of the
company to another segment/profit centre.

6.17 SELF-ASSESSMENT QUESTIONS

1) Explain the concept of profit centres.
2) Examine the relationship between corporate philosophy and style, and
profit centre autonomy.
3) “Profit centre autonomy is a dynamic concept.” Why? Explain and
i1lustrate.
4) What is the rationale behind profit decentralization? Is business diversity
anything to do with complexity?
5) What considerations should guide corporate managers in establishing
profit centres?
6) Explain the benefits of profit decentralization and critically comment
upon them.
7) What are the major difficulties that could arise in the creation of profit
centres and how could they be overcome?
8) Distinguish between Genuine and Artificial profit centres. Why are
artificial profit centre established?
9) Giving some examples of artificial profit centres, state what issues could
182 arise which need to be settled.
10) How far the practice of the concept of profit centres is popular? Cite Profit Centres

some facts and figures in support of your-answer.

11) Examine the motivational value of profit centres, citing any research
study in this respect.
12) How would you determine the profitability of a profit centre? Explain the
methods that could be used in this context.
13) Explain the process and importance of setting profit targets for profit
centres. Why should budgets be prepared for profit centres?
14) What are some of the problems that could arise in reporting the profits of
profit centres? What concerns should be kept in mind while analysing
profit centre results?
15) Explain the various aspects and issues involved in performance appraisal
of profit centres. What are the important considerations in such
appraisal?
16) Can an expense center be converted into a profit center? Explain with
examples.

17) In a belt-tightening measure, the BlueBerry Company is examining its

four divisions to close any unprofitable ones. Common costs incurred at
the Corporate level have been distributed to each Division in proportion
to sales revenue. Division level costs are considered avoidable if a
Division is shut down. However, the corporate costs cannot be avoided
as long as some of the Divisions continue operation. The Corporate
headquarters costs amount to 995,000 (semi-annual). The following data
represents semi-annual results:
Divisions ('000s)
Total North South East West
Sales 4800 1820 770 1240 620
Costs (Direct 4450 1225 380 1685 360
and allocated)
Profits/(Losses) 350 295 190 (545) 210

Required:
a. Based on the above Information, what recommendations would you
make concerning possible division closes?
b. Since the above data represents semi-annual information, what other
variables should be included in the decision to close down a division?
1. Following is the information on Paragon Company's three product lines:
Product Lines
1 2 3
Revenue 71,60,000 19,00,000 42,00,000
The flexible cost percentage 60% 50% 40%
183
Management of sales
Control Structure
Other costs 8,59,200 2,37,500 6,93,000
Allocated avoidable corporate 3,49,000 1,56,000 6,98,000
costs
Allocated unavoidable 5,70,800 2,06,500 24,000
corporate costs
• Construct a profitability margin for the divisions to enable performance
evaluation.
• At what levels should the profitability between divisions be compared?
Give reasons.

6.18 REFERENCES & FURTHER READINGS

Anthony, R. N., and Govindarajan, V., 1998, Management Control Systems,
Tata McGraw-Hill, p. 173.
Anonym. (2019). Management Control Systems: Different Types of Control
Management. On the Effectiveness, the Advantages and the Disadvantages.
Germany: GRIN Verlag.
Bhatia, M. L., 1986, Profit Centres: Concepts, Practices and Perspectives,
Somaiya Publications, pp. 7-21.
Bhatia, M. L., 1983, Motivational Value of Profit Centres: Myth and Reality
Cost and Management, Nov.-Dee., pp. 31-35.
Drucker. Peter, 1974, Management: Tasks, Responsibilities, Practices,
Harper & Row.
Flamholtz, E. G. (2012). Effective Management Control: Theory and
Practice. United States: Springer US.
Horngren, C. T., Cost Accounting: A Managerial Emphasis, Prentice-Hall of
India, p. 693.
Hoozée, S., Bruggeman, W., Slagmulder, R. (2018). Management Control:
Concepts, Methods and Practices. United Kingdom: Intersentia.
LEMKE, K. W. (1970), In Defence of the 'Profit Center’ Concept. Abacus, 6:
182–189.
Mottis, N., &Ponssard, J. P. (2001). Value-based management and the
corporate profit center. In European Business Forum (Vol. 8, pp. 141-7).
Prentice-Hall.
Nilsson, G., Anthony, R., Hartmann, F., Kraus, K., Govindarajan, V. (2020).
EBOOK: Management Control Systems, 2e. Spain: McGraw-Hill Education.
Vancil, Richard, F., 1979, Decentralization: Management Ambiguity by
Design, DowJones-Irwin.

184
UNIT 7 INVESTMENT CENTRES Investment Centres

Objectives

After studying this unit, you should be able to:

• know the meaning and rationale of investment centres;

• understand the techniques for measuring overall performance of
investment centres and differentiate between ROI and RI (or EVA) with
their underlying implications;
• develop an appreciation for the issues involved in measuring the
investment base;
• comprehend the alternative methods for valuation of assets for
determining the investment base;
• grasp the need for and significance of economic appraisal of investment
centres;
• appreciate the issues involved and the need for appraising performance
of the managers of investment centres on a broad spectrum.

Structure
7.1 Introduction
7.2 Investment Centres
7.3 Objectives of Investment Centres
7.4 Overall Performance Measures
7.5 Return on Investment (ROI) as a Performance Measure
7.6 Precautions While Using ROI
7.7 Residual Income (RI) as a Performance Measure
7.8 ROI and RI (EVA): A Comparative Analysis
7.9 Measuring Investment Base
7.10 Allocation of Central Office Assets
7.11 Asset Valuation Alternatives
7.12 Replacement Costs (Historical vs. Replacement Costs)
7.13 Economic Appraisal of Investment Centres
7.14 Appraisal of Managerial Performance
7.15 Summary
7.16 Key Words
7.17 Self-assessment Questions
7.18 References
7.19 Further Readings

185
Management
Control Structure 7.1 INTRODUCTION
In the previous three units, you learnt about Responsibility Centres, Profit
Centres, and Cost Centre. This unit is the last link in the chain of
responsibility structure. The journey that began with Responsibility' Centres
ends with this unit on Investment Centres.

The unit first explains the concept of investment centres and the rationale
behind their establishment. It then focuses on the overall effectiveness
measures of ROI (Return on Investment) and RI (Residual Income). The
merits and demerits of the two measures are analysed with a comparative
evaluation. The unit then shifts its focus on an important but ticklish problem
of measuring the investment base of investment centres. Thereafter, the topic
of allocation of central office assets is taken up. This is followed by a detailed
discussion about the alternative methods for valuation of assets and their
advantages and disadvantages. The unit concludes with the topics of appraisal
of investment centres as economic entities, and appraisal of managerial
performance of investment centres.

As you read the unit, you might feel that you are stuck up, as you may find
some portions of the unit a bit difficult to comprehend, but you should not get
unnerved. We suggest that you read those portions slowly and more than
once, and you will find that you have grasped those portions so easily.

We learned that profit centers have to meet their expenses and generate a
surplus. Now we raise the question-surplus on what? Is profit an absolute
measure or is it relative? In this Chapter, we learn to measure profit as a
function of investment. We understand various ways to evaluate divisional
performance and identify suitable performance measures.

Management of a profit center involves managing revenues and expenses.

When revenues exceed the expenses the profit center earns a profit. When
profits are maximized, it can be reasonably assumed that a profit center
performs well. However, unless the profit is measured as a function of capital
invested to earn the profit, the measure remains incomplete.

Investment centers are a part of responsibility centers involved in utilizing the

capital directly to contribute to the profits of the organization thereby
measuring efficient utilization of the resources. When investments are
substantial, the key measure of success is return on investment. However, for
service organizations capital investment is insignificant and they may use
other measures to evaluate success. The performance of this center is
evaluated by comparing the profits earned i.e. output with the assets
employed to earn that profit i.e. input. Just focusing on the profits without
concerning about the amount of resources being used will mislead the
performance evaluation and lead to ineffective control. Comparing the
absolute profit performance of different business units is meaningless unless
one considers the amount of assets employed to generate the profits.
186
Historical Perspective on Investment Centre Investment Centres

In the 1900s businesses had a single focus- textile or railroad or steel, etc. For
the business to be profitable, costs needed to be controlled. Control of costs
naturally resulted in better profits. When businesses stabilized then the most
important decision was that of scale. Growth of a business results in
increased production backed by increased demand, resulting in reduction of
unit costs of production. This came to be known as benefiting from
economies of scale. In other words, the business was becoming more
efficient in its use of its inputs to produce a given level of output.
Du Pont Powder Company, formed in 1903, had a new organizational
challenge not faced by nineteenth-century organizations- to coordinate and
allocate resources to the manufacturing and selling units performing quite
different activities. The concept of measurement of return on asset was that
“the true test of whether the profit is too great or too small is the rate of return
on the money invested in the business and not the percent profit on the cost”.
Du Pont developed a scale known as “Return on Investment” to measure the
performance of their divisions in terms of maximum profits as a percentage
of capital employed.
Similarly, Matsushita Corporation of Japan developed an Internal Capital
System in the 1930s.
Internal Capital = Standard Working Capital+ Fixed Assets-Reserves.
Interest charged for internal Capital was 1% per month, paid to Central
Office, each month. Central Office levied 3% of Divisional Sales to cover
headquarters expenses, paid to Central Office each month. After deducting
this payment, divisional net profit was expected to be equal to 10% of sales
which was the target goal for profit management.
If divisional funds fell short of the required amounts, the division could
borrow temporarily from the Central Office. Any excess cash could be
deposited in the Matsushita Bank, where it earned a competitive rate of
interest. When a division required large funds for a major new investment,
the proposal was submitted to the Central Office for approval and funding.
Thus businesses had evolved from merely deciding the scale of production to
allocating capital to their various businesses based on the return generated on
each of the businesses

7.2 INVESTMENT CENTRES

Investment centre is a unit of the organization whose manager is responsible
not only for inputs (operating costs) and outputs (revenues) or for producing
a profit but also for the assets employed. There is not much difference
between profit centres and investment centres. Investment centres, in fact, are
profit centres with extended responsibility for effective utilization of
investment, i.e., responsibility for a return. As a matter of fact, all investment
centres are profit centres, but all profit centres need not necessarily be
187
Management investment centres.
Control Structure
In the real world, the phrase profit centres is more commonly used to denote
both profit centres as well as investment centres. In a sense, investment
centre is a special type of profit centre. Because the application of the
concept of investment centre presents some ticklish problems in measuring
assets employed in the centre, it warrants a separate discussion; and hence,
this unit.

It must be said at the outset that a focus on profits without consideration of

assets employed to generate those profits is an adequate basis for control.
Except in certain types of service organizations, in which capital employed is
insignificant, an important objective of a profit-oriented company is to earn a
satisfactory return on the capital employed or used in the company. A profit
of Rs. 10 lakhs on a capital of Rs. 100 lakhs does not represent as good
performance as a profit of the same amount on a capital of Rs. 50 lakhs,
assuming that both the companies have similar risk profile. Unless the
amount of assets employed is taken into consideration, it would be difficult
for the management to compare the profit performance of different business
units or with similar outside companies. The comparison of absolute profits
would not be meaningful if business units use different amounts of resources.
The greater the resources used, the greater should be the profits. The
percentage-based (relative) comparisons enable judging the financial
performance of the unit managers as well as judging how units are doing as
economic entities, and whether resources are being allocated judiciously. The
purpose of relating profits to investments is to motivate business unit
managers to accomplish the objectives of the company.

If a manager is evaluated only on the level of profits, without regard to assets

employed, the temptation is to expand assets (for example by increasing
inventories or extending receivables) as long as any incremental profit can be
earned on the expanded assets. Such actions, however, will lower the
divisional ROI, and would not be undertaken if an ROI performance measure
were to be used.

An investment centre is the highest level and the broadest of all the
responsibility centres from the standpoint of decentralized management
control. It encompasses all the elements of profit and investment and affords
the broadest measure of financial performance.
In creating or establishing investment centres, the management would be
guided by the same set of criteria as was discussed in unit 6 in relation to
Profit Centres:
(i) Factors to which top management wishes to direct the unit manager’s
attention;
(ii) Factors which can be controlled by the manager of the unit; and
(iii) Education and experience of the typical manager of this type of unit.
To be truly called an investment centre, the manager, apart from the profit
variables, must be able to influence, to a fair extent, the size of the investment
188 base. The objective of establishing an investment centre in a decentralized
organization is to provide an incentive for the unit/division manager to Investment Centres
purchase, retain, or retire assets/facilities to maximise the interests of his own
unit as well as the organization as a whole. For the purposes of this unit, the
terms investment centre, division, segment, business unit, or simply the unit
carry the same meaning, i.e., these terms will be used synonymously for
investment centre.

At the first glance, the investment centre concept appears very attractive, but
as we proceed you will know that it is beset with several technical and
conceptual problems or issues. We shall examine all such problems as we
proceed with our discussion. We shall also discuss how these problems could
be remedied, or at least minimized so that the investment centre structure is
put on a sound keel. What is important is the proper design of the
responsibility centre structure of which investment centres are a part. The
responsibility centre structure should be so designed that it motivates
managers toward goal-congruent behaviour, though it may be difficult to
evolve what is called a perfectly goal congruent’ responsibility structure. If
genuine efforts are made in that direction and they produce a responsibility
structure that is least dysfunctional, the outcome should be regarded as
satisfactory.

Some important questions that arise in the context of investment centres are:

• How do we measure the overall performance of an investment centre?

• What methods or techniques are available for measuring the performance
of an investment centre?
• How do we determine the profitability of the investment centre?
• How do we determine the investment base of an investment centre?
• Should we make a distinction between measuring the managerial
performance and economic performance of an investment centre? And if
we do, then how do we accomplish the task?

As far as determining the profitability of an investment centre is concerned,

the issues encountered are the same that were discussed in Unit 6 on Profit
centres. Hence, they will not be taken up here (you may please refer to the
appropriate section in Unit 6).

7.3 OBJECTIVES OF INVESTMENT CENTRE:

The objective of the investment center is to make sound investment
decisions. That means in totality it is concerned with costs, revenue, and the
assets utilization factor. Therefore the objectives of the investment center can
be listed as follows:
Measurement of profit against investment
One of the most important objectives of the investment center is to measure
the profits not in absolute terms, but as a function of investment.

189
Management For example, if Division A has earned a profit of Rs.2,00,000/- and the assets
Control Structure
relatable to Division A are Rs.100,00,000/-, then the profit in relation to the
investment is 2%. However, if Division B has earned Rs.1,00,000/- on an
asset base of Rs.10,00,000/- then the profit earned by Division B is 10%. On
a relative basis, Division B would be more profitable even if the absolute
profits earned by both the Divisions are the same.
Control on cost, revenue, and asset utilization
For a profit center to perform well, the vital parameters are profitability and
asset utilization. Profitability is a function of cost control and revenue
maximization. However, an investment center also seeks to measure the
profit against assets utilized. Hence the objective of an investment center is
not only control of cost and maximization of revenue but also proper asset
utilization.
Deciding the priority of deployment of capital
While making capital investment decisions, the project which promises the
most return on the investment or assets deployed will be the preferred
investment. Also, when there are multiple profit centers in a business the
capital will be used in that profit center where the returns are better than the
other profit centers.
Activity 1
What are the important objectives of the investment center?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

7.4 OVERALL PERFORMANCE MEASURES

Broadly speaking, there are two ways of relating profits to assets employed or
measuring the overall performance of an investment centre; namely—

• Return on Investment (ROI); and

• Residual Income (Rl) or Economic Value Added (EVA).

ROI is a ratio of business units’ profits to assets employed to earn that profit.
The prime concern of an investment center is how efficiently it uses its
assets. Profit centers measure the profit in absolute terms whereas investment
centers measure it in terms of assets utilization efficiency. Thus investment
center acts as a special type of profit center and measures whether profits are
adequate and commensurate to the assets employed.

Usually, the business unit manager strives to generate adequate profits from
190
the assets/ resources deployed, and invest in additional assets/resources, to Investment Centres

augment returns.

Return on Investment
(ROI) measures profits earned per rupee of investment. ROI is calculated as:
Profitability Sales
Sales Assets Employed
OR
Earnings Before Interest and Tax
100
Capital Employed
Profitability to sales represents the margin which is the ratio of operating
income to sales
Sales to Assets employed represents asset turnover which shows how
productively assets are being used to generate sales

ROI is a ratio; the numerator being income (as reported on the income
statement), and the denominator being assets employed. EVA is an absolute
amount rather than a ratio. It is calculated by subtracting a capital charge
from the net operating income.

You will appreciate that for the investors of capital in a company or its
owners, profit is too vague a goal, for it does not consider the investment of
the shareholders. If the revenues are higher or expenses are lower in a year,
one could not say conclusively that shareholders are better off, unless one
relates the profits to shareholders’ investment which is their input. If
investment is increased, profit must be increased correspondingly in order to
provide a satisfactory return to those who provide the resources needed to
make the additional investment. When profit is related to investment, the
resultant measure is known as ROI or Return on Investment, that is, the profit
divided by the investment in a particular period and it becomes more
meaningful to the owners.

Dilating on ROI, Alfred Sloan of General Motors (USA) said, “I am not

going to say that rate of return is a magic wand for every occasion of
business. There are times when you have to spend money just to stay in
business, regardless of the rate of return. Competition is the final price
determinant and competitive prices may result in profits which force you to
accept a rate of return less than you hoped for, and for that matter to accept
temporary losses. And, in times of inflation, the rate of return concept comes
up against the problem of assets undervalued in terms of replacement.
Nevertheless, no other financial principle with which I am acquainted serves
better than rate of return as an objective aid to business judgement.”

ROI is a dominant objective of the owners of business enterprise. The

measurement system of responsibility system, according to Sloan, should
reflect a portion of this return objective, but it depends upon the resources (or
191
Management assets) that have been placed under the custody of the responsibility centre
Control Structure
manager.

To understand the logic behind the concept of ROI, it is desirable to break it

down into its elements/components which are shown in the DuPont Chart
(Figure 7.1).

Let us first define ROI, which is —

Net Profit Revenue – Expenses
ROI = ------------- = ---------------------------
Investment Investment

The above equation may be defined further in terms of profit margin and
investment turnover as shown in Figure 7.1. In other words, ROI may be
divided into components:

Net Profit as a percentage of sales revenue and Turnover of investment in

relation to sales revenue. Profit margin may be broken down into its elements
and Investment Turnover may be broken into its elements as is clear from
Figure 7.1.
Return on investment 6%

Earnings as a Turnover
percent of sales 4% 1.5

Sales Net Income Total investment Sales

$3,000,000 $1,20,000 (assets) $3,000,000
$2,000,000

Total Cost Sales Current assets (also

$2,280,000 $3,000,000 Fixed includes small
assets amounts of deferred
$1,300,000 charges which are
not charted $700,000
Cost of Operating
goods sold expenses
$2,580,000 $90,000
Inventories Cash
$300,000 $50,000
Depreciation Interest
$100,000 $45,000

Accounts Marketable
Taxes Less other
receivable securities
$80,000 income
$200,000 $150,000
($15,000)

Fig. 7.1: Relationship of factors affecting return on investment

Source: J. Fred Weston and Eugene F. Brigham, managerial Finance (New York: Holt,
Rinehart and Winston, 1969), p75.

Let us suppose a company has total assets of Rs.2,00,000, and net income of
Rs.40,000; its ROI will be Rs.40,000/Rs.2,00,000 = 20 per cent.
192
Residual Income (RI) Investment Centres

Under the residual income method, divisions are charged with an opportunity
cost of capital, set by the corporate management, for the investment
employed in the divisions. Usually the rate is set somewhat below the
company’s estimated cost of capital so that the economic value added (EVA)
of a business unit will be above zero. Residual income is the income made by
the division minus the charge for capital. The capital charge may be a
uniform rate (say 10% for all kinds of assets), or it may be different for
various categories of assets if the firm wishes to incorporate a risk premium
within the capital charge for various types of assets. Some companies may
use a lower rate for working capital than for fixed assets on the ground that
working capital is less risky than fixed assets because the funds are
committed for shorter period of time.

Residual income is also known as Economic Value Added (or EVA), since
whatever the amount of income over the capital charge, it is the economic
value that has been added by the division as its contribution to the value
addition of the whole company. Taking the similar data as we had in respect
to ROI, that is: the company’s total assets are Rs.2,00,000 and net income
Rs.40,000. The company makes a capital charge of 10% for the investment in
the division. The RI will be Net Income-Capital Charge which will be
Rs.40,000 - Rs.20,000 (Net Income - Capital Charge at 10% of investment) =
Rs.20,000.

7.5 ROI AS A PERFORMANCE MEASURE

You will recall that ROI is equal to Net Profit divided by Investment, and Net
profit is equal to the difference between Revenues and Expenses. In order to
determine the ROI for an investment centre, it is necessary to accurately
define profits (revenues— expenses) and investment base of a responsibility
centre. How do we define profits or profitability was discussed in Unit 6
dealing with profit centres, and there is nothing new to add or elaborate on
that here. However, how do we define ‘investment’ will be discussed in this
unit in necessary depth.

For this unit we will use the terms capital invested and capital employed (in
an investment centre) interchangeably, though, theoretically speaking, a
distinction is made between the two terms. Capital invested means all
business assets available in a division/ investment centre; and capital
employed (or total assets employed) means assets being actually used in the
division. The latter figure is calculated by deducting any assets which are in
excess of the requirement of an investment centre or are lying idle (such as
vacant land, or machinery and equipment that has remained unused).

193
Management Benefits of ROI
Control Structure
Advantages of using ROI-
The ROI approach ensures that profits are viewed as a function of assets
employed
ROI incentivizes the manager to maximize returns by controlling costs and
eliminating non value-added activities
It encourages optimum investment into assets and increase revenues without
additional investment

The primary question in evaluating a division/unit as an economic entity is

whether the profit generated by the division is adequate to support the
investment made in it. (This kind of evaluation is similar to the techniques
adopted for evaluating capital expenditure alternatives). The ultimate test of
profitability, as is often stated, is not the absolute amount of profit, but it is
the relationship of profit to capital invested.

ROI has a natural appeal because, as we noted in the preceding section, it

blends in one measure all the major ingredients of profitability. It focuses on
the often neglected aspect of management responsibility, i. e., investment in
assets, and thus motivates the managers to optimize the return on assets
(current and fixed). The ROI index encourages the managers to economize in
the use of capital, as other things remaining the same, the lesser the capital
employed in the division, the higher will be its ROI. It thus provides an
incentive for capital economizing moves such as disposing of redundant
assets or choosing a less capital intensive production technology or processes.
However, a similar argument can also be made for RI (Residual Income).

Being a ratio, the ROI acts as a common denominator so that comparisons

become easy to apply between divisions and opportunities elsewhere. Since
the overall return on investment for the company is an important
consideration for any decision the prospective investor takes, it is natural for
the top management to delegate responsibility down the line to divisional
managers in the same fashion.

A useful approach to computation of ROI is through computations of its

components, i.e., Asset Turnover Rate and percentage Margin on Sales,
which are two basic ingredients of profit making. The Asset Turnover Rate
measures the velocity of utilization of assets employed (or resources used).
Any action is beneficial that boosts sales or reduces invested capital or
reduces costs, while holding the other two factors constant. The two-step
approach gives management a better understanding of the elements leading to
the final result. Sales, profits and assets employed are the three factors in the
ROI equation. With sound planning and efficient operations, the combination
of these three factors can be optimized.

In a company with divisions operating in diverse industries/activities, the

profit margins and turnover ratios will be different. For example, the heavy
194
industry division with products tailor-made to customer specifications will Investment Centres

have different profit margins and turnover ratios than a division in any of the
mass producing industries of highly competitive consumer products. Hence, a
comparison of Asset Turnover Rate and Margin on Sales would not be very
meaningful. Each measure favours a particular type of operation - Profit on
Sales for high mark up and Asset Turnover for high volume. Here, the key to
the problem of course is to use ROI which considers mark ups and volume,
permitting management to focus on profits generated on its required
investment. In a multi-industry company, the three basic factors cannot be
uniform due to diversity of operations.

In short, ROI is a comprehensive and generally accepted measure of

performance. It is a common denominator which provides for meaningful
inter firm and intra firm comparisons. ROI provides an incentive to use
existing assets to the fullest and to acquire additional assets only when they
offer potential for maintaining or increasing an acceptable rate of return.
Further, ROI is easily understood and interpreted.

Limitations of and Difficulties with ROI

Though, conceptually, ROI is an ideal index which relates accomplishments

to resources used and tends to tie together the many phases of financial
planning, sales objectives, and cost control and profit goal, practically,
however, it has been regarded as an imperfect or incomplete measure of
performance. That is why; it is often asserted that this technique should be
used along with other performance yardsticks.

The limitations of ROI have been classified into two categories: technical and
implementation. The first arises from those conditions which cause
incongruities between investment centre objectives and company objectives,
and which result in motivating investment centre managers to take
uneconomic actions. The second type include those conditions that result
from the inability, under many circumstances, to evaluate accurately the
profit performance of investment centre managers.

Let us examine what those limitations are?

It has been stated that ROI is a risky method of measuring and controlling
decentralized investment centres. While in theory ROI appears to be fine as a
control technique, in practice it may result in decisions by managers which
are not in conformity with the organisational objectives. The danger of ROI
criterion is not the specific decision to invest, which could be made on the
basis of cash flow calculations, but rather the desire of the investment centre
manager to seek a high rate of return which could lead him to turn away from
opportunities for profitable expansion. The most serious objection raised
against ROI is that it provides too strong an incentive to economize on capital
and it may discourage investments which otherwise are attractive from the
view point of the company as a whole. This is illustrated in the next section.
Another problem with ROI control is that it picks up all the weaknesses and 195
Management limitations connected with the measurement of investment, earnings, and
Control Structure
allocation of costs. It is extremely sensitive to accounting practices affecting
the computation of net earnings and the investment base, including the
depreciation calculations (these topics have been discussed in a later section).
The definitions of income and investment adopted in a particular situation
can have a significant influence on the behaviour of managers whose
performances are being measured. A clever manager whose objective is to
maximise ROI can identify the specific set of variables in the computation of
index and act accordingly.

7.6 PRECAUTIONS WHILE USING ROI

Even though ROI is a very popular measure for measuring the performance
of an investment center, it gives ample scope for manipulations. Some of the
specific instances where ROI could be adjusted by making accounting
adjustments are discussed below:

Expense versus capitalize

Intangible expenses create benefits for a Division for the future period and
are hence treated as assets. For example, research expenses. For such
expenses on intangibles, discretion exists as to whether the expenditures
should be capitalized or expensed in the same year in which they are
incurred. The division may decide to write off the expense in a single year
even though the benefits may accrue over several future years. Such failure to
capitalize expenses with future benefits will penalize earnings in the short run
until the steady state is reached and will overstate the ROI in the steady-state.

For example, if a research expense of Rs.3,00,000/- is written off in a single

year, but the benefit of the expense is available for three years, then the year
in which the money is spent will reflect a low ROI. However, in the next two
years in which no expense is incurred but benefits are received, the ROI will
be overstated. This is because the expenses on intangibles will not be
included in the asset base but have been written off as an expense in the year
in which it was incurred.

Leasing of Assets

Sometimes firms decide to lease assets rather than purchase them. The profit
will reduce because of the lease rentals paid, but the asset base reduces
disproportionately since the cost of the asset is not included in the
denominator. Therefore ROI may be grossly overstated thereby giving an
incentive to managers to lease assets rather than purchase them even if no
economic benefit arises on account of the same.

Example 1:

ABC limited operates some of its divisions as Investment Centers and

accordingly their performance is measured by the ROI that they generate.
196
They consider a lot of projects that require capital investment and the ROI Investment Centres

generated by each of these investments will be a major factor in identifying

favorable projects.

R Division has an average investment of Rs.1,00,00,000 presently. This is not

expected to change for the next 4 years.

The Division is considering an additional capital investment of

Rs.1,00,00,000 at the beginning of the year 2022. The project is expected to
generate a cash flow of Rs.40,00,000 every year for the next 5 years before
tax. The company uses the straight line method to provide depreciation of the
asset for income tax purposes and wants to write off the entire asset in the
first four years itself.

Alternatively, there is a proposal that the company need not own the assets
but lease them. Leasing has clear advantages in terms of the number of years
for which the asset needs to be held. The division can surrender the asset,
provided it is used for at least three years. Under these terms, the company
can pay a lease rent of Rs.35,00,000/- per annum.

The Division manager is keen that in the initial years of the project, there
must be a higher ROI so that it will reflect positively in his appraisal.

Required:

Calculate the post-tax earnings under both purchase and lease options
assuming a tax rate of 50%. Also, calculate the ROI under both options for
the years ending 2022, 23, 24 25, and 26 assuming that the division uses the
Sum of the digits (for the full five years) to depreciate the assets of the
Division.

At a cost of capital of 5%, which of the options is better for Division R? You
may assume that the assets will be used for 5 years under both options.

What are the dysfunctions that the ROI approach throws up in this case?
Solution
In Case an asset is purchased
Cash Depreciation Income Tax Asset value ROI Cash flow
Flow (50%) (st. line dep
method) adjusted
40 00 000 40 00 000 -- -- 1 80 00 000 40 00 000
40 00 000 30 00 000 10 00 000 5 00 000 1 60 00 000 3 35 00 000
40 00 000 20 00 000 20 00 000 10 00 000 1 40 00 000 7 30 00 000
40 00 000 10 00 000 30 00 000 15 00 000 1 20 00 000 13 25 00 000
40 00 000 40 00 000 20 00 000 1 00 00 000 20 20 00 000

Note:
Differential cash flow is calculated as cash inflows from purchase minus cash
inflows from the lease. For example, it is Rs.40,00,000 in Year 1 in case of
197
Management purchase and Rs.250,000/- in case of lease. So the differential cash flow is
Control Structure
Rs.37,50,000/- in Year 1
These differential cash flows are discounted using a discount rate of 5%. For
a better understanding of this concept, students are advised to go through the
information on the “time value of money”
Discounted cash flow is calculated as Cash Flow* (1/(1+Discount
factor/100)) for year 1; for subsequent years, the denominator is raised to the
power of n where n is the period. So for year 2, it is Cash Flow*
(1/(1+Discount factor/100)^2) and so on.
The dysfunctions that arise on account of the use of ROI is that the economic
benefit of the decision is overlooked. Purchase is a better economic decision,
whereas, leasing results in better ROI in Year 1 because the asset base is low.
Purchase decision looks better in the later years when the asset is depreciated.
So a manager who looks at a one or two-year frame is likely to choose a
lease, whereas, in the long run, it is not a good choice.
Choice of Depreciation method
The choice of method of depreciation also affects the asset base and results in
different ROI. Some methods of depreciation have the effect of depreciating
the asset faster than other methods. For example, the sum of the year digit
method1 has the effect of depreciating the asset differently than the original
cost method. For example, if the sum of year digit method is used, then the
ROI in the earlier years is likely to be high and later years will reduce. So a
manager wanting to increase the near-term profits of his division is likely to
choose this method of depreciation over others.

7.7 RESIDUALINCOMEASAPERFORMANCE
MEASURE
To overcome some of the difficulties and limitations of ROI approach as a
yardstick for measuring the performance of investment centres, another
approach called Residual Income (RI), first popularized by General Electric
Company (of USA), has been devised.

Residual Income- is the difference between operating income and the

required return on assets
Residual Income =Operating income - (Minimum rate of return ×Operating
assets)
Economic Value Added
Economic value added (EVA) is after-tax operating profit minus the total
annual cost of capital.

1
Sum of the year digit method works as follows:
Suppose the equipment costs Rs.5000/- and the life of the equipment is 3 years, depreciation
for year 1 is 3/ (3+2+1)*5000; Year 2 is 2/ (3+2+1)*5000 and year 3 is 1/ (3+2+1)*5000.
This method ensures that the depreciation in the initial years is faster than the depreciation in
198 the later years.
EVA =After-tax operating income, that is: Investment Centres

Profit- (Weighted average cost of capital ×Total capital employed)

Since the income statement of the division includes a charge for the
opportunity cost of capital based on rates adjusted for the riskiness of the
assets employed, it has been said that residual income reflects the true profit
of the division. The divisions may differ not only in profit potential but also
with respect to the nature of assets employed; therefore the budgeted levels of
residual incomes would differ from one investment centre to another.

The RI measurement solves the conceptual problems associated with ROI

measure. Under RI, different cut off rates can be charged for different assets
in the same division, while similar cut off rates can be charged for similar
types of assets in different divisions.

Under RI, each division is assigned a budgeted RI. The division manager
may then concentrate on decisions that maximise RI and is very likely to
pursue goal congruent behaviour.

ROI vs. RI: Survey of Practices

How far the above two measures of determining the overall effectives of the
units in the USA and in India are popular in actual practice is presented in
Table 7.1 and Table 7.2. Accordingly to the two studies in Table 7.1 in the
USA, 74 per cent and 78 per cent of the respondents used investment centre
idea. Of the American companies using investment centre idea under study 1,
65 per cent used ROI and only 2 per cent used RI, while 28 per cent used
both ROI and RI (i.e., in all 30 per cent used RI or EVA). Under study 2,36
per cent respondents measured EVA or RI for their investment centres. The
figures for how many used F^.01 or RI on standalone basis are not given.

As far as India is concerned (see Table 7.2), 77 per cent and 4 per cent used
ROI and RI on standalone basis, while 15% used both ROI and RI; and 4 per
cent used ROI with some other measure.

Table 7.1: Methods Used to Evaluate Investment Centres (USA)

Study 1 Study 2
(1978) (1994)
Number of usable responses 620 638
Companies with 2 or more investment centres 74% 78%
Companies using only ROI 65%
Companies using only RI or EVA 2%
Companies using both ROI and RI
Companies using either ROI, or RI, or both 36%
Sources:
Study 1: James S. Reece and William A. Coot, Measuring Investment Centre
Performance, Harvard Business Review, May-June 1978, pp.28-49.
199
Management Study 2: V. Govindarajan, Profit Centre Measurement: An Empirical Survey,
Control Structure
cited in Anthony, R. N. and Govindarajan, V. Management Control Systems,
Tata McGraw-Hill 9th ed., p. 255.
# Reece and Cool had asked for separate information on use of ROI and RI,
and joint use of ROI and RI, 'but no separate information was asked for in
Govindarajan’s survey.

Table 7.2: Methods Used to Measure Performance of Investment Centres

(India)

Number of usable responses 65

Companies with investment centres 26
Companies using only ROI 77%
Companies using only RI 4%
Companies using both ROI and RI 15%
Companies using ROI with some other method 4%
Source: Bhatia, M. L.. Performance Measurement of Profit Centres: Practices and
Perspectives, The Chartered Accountant, Volume XXX, No.9, March 1982, pp.586-593.

A study (1980) by V. Govindarajan and B. Ramamurthy (cited in Robert

[Link] and V. Govindarajan: Management Control Systems, Tata
McGraw-Hill. 9th ed, p.256) found 8% of the companies (out of 27) using RI
or EVA. However, figures for companies using only ROI, or both ROI and
RI are not given.

Tables 7.1 and 7.2 amply show that ROI enjoys wider acceptability both in
the USA and India.

7.8 ROI AND RI (EVA): A COMPARATIVE

ANALYSIS
The significant characteristic of both ROI and RI is that they direct the
attention of the investment centre manager toward minimizing the investment
in assets relative to net income. If the manager can maintain the net income
while reducing the asset investment, ROI will be increased because the
denominator of the fraction is made smaller. The RI, however, directs the
manager’s attention more explicitly to the amount of income earned relative
to investment. Let us explains this a bit. Residual income is:

RI = Net Income - (Investment x Required Minimum Rate of Return)

The required rate of return, as we have stated earlier, is the capital charge, a
charge for the use of capital invested in the division by the company. If the
manager has a zero residual income, it means the division has exactly
achieved the target return on investment. A positive RI means that the target
has been exceeded, and a negative RI means that the target has not been
achieved. The amount of the capital charge, and thus RI, moves in the same
200
direction as the amount of investment in the division. Investment Centres

All the difficulties in relation to what should be included in the investment,

and at what amounts, exist with RI, as with ROI. Investment normally is
defined as total assets at net book value, as is the usual case with ROI
computations. You might ask, what then is the advantage of using Residual
Income? The primary reason is that it solves one additional problem which
exists in the use of ROl.
Under ROI, high-return divisions may be tempted to refuse investment
projects which, though desirable from corporate point of view, would reduce
the division ROI. This temptation does not exist if financial performance is
measured on a residual income (RI) basis.
There are several differences between ROI and EVA. They are:
Economic value added is an absolute measure, whereas ROI is a percentage
measure.
Since EVA is an absolute measure, it can account for scale differences. For
example, if ROI is 10%, then it can be Rs. 10 earned on 100 or Rs. 1 crore
earned on a base of 10 crores. ROI cannot account for the differences in
scale, whereas EVA can account for it. EVA of Rs.100,000/- would imply a
certain scale of activity, whereas EVA of Rs.100,00,000/- will imply a larger
scale of activity.
EVA represents the returns for the owner of the capital since it is interest
adjusted, whereas ROI represents the return for the specific project since
interest costs are not deducted.
EVA is the measure of profits whereas ROI is a measure of efficiency since it
measures the return generated from an asset without reference to the source
of capital.
Is Eva Preferable to Roi?

Even though EVA is a superior measure as compared to ROI, ROI is a

preferred measure by most managers for practical purposes. The reasons why
ROI is preferred to EVA are as follows:

The thrust for the manager is to maximize returns and not maximize
accounting-based measures

The cost of capital is a figure that divisional managers are not willing to
commit on
There would be no uniformity between published reports and EVA
A percentage measure is more comfortable than an absolute measure
Despite the long-time lack of acceptance of EVA most of the bonus plans for
senior executives are based on EVA
Are absolute measures better than relative measures? Why/Why not?
Consider the following Example:
201
Management Example 2
Control Structure
A company is satisfied to invest in projects which promise an ROI of 12 per
cent because this exceeds the cost of capital for the company. The Supermax
division, however, has a record of achieving a 25 per cent ROI. A project is
proposed to the. Supermax division which would require an investment of
Rs.4,00,000 and would generate added net cash inflows of Rs.95,000 per year
for next ten years. Present value analysis shows that this proposal would give
a return of approximately 20 per cent. Since the expected return exceeds the
12 per cent minimum requirement, it should be accepted, other things
remaining the same. But what would it do to the Supermax ROI?

Suppose that the Supermax division presently has total assets (net book
value) of Rs.8,00,000 on which a net income of Rs.2,00,000 is being earned,
resulting in the division’s ROI of 25 per cent. The new project would add
Rs.95,000 less annual depreciation of Rs.40,000 (assuming straight-line
depreciation and no scrap value), that is, Rs.55,000 will be added to the net
income. It will add Rs.4,00,000 to the investment. Thus, the new ROI of the
division would be 21.3 per cent.
Net Income Rs. 2,55,000
----------------------------------- -- = ------------------ = 21.3%
Total Assets at net book value Rs. 12,00,000

With 21.3 per cent return, it is a desirable project from the corporate
viewpoint, but might be rejected because it would reduce Supermax
division’s ROI from 25 per cent to 21.3 per cent. Even though the division’s
ROI remains well above the corporate target of 12 per cent, division manager
might be reluctant to undertake this investment which would reduce his ROI.
What would be the result if the company were using the RI measure for the
investment centre?
Residual income without the new project is as follows:
RI = Net Income – (Investment × Required Minimum Rate of Return)
= Rs.2,00,000 – (Rs.8,00,000 × 12%) = Rs.2,00,000 – Rs.96,000
= Rs.1,04,000
The positive residual income shows that the division is exceeding minimum
requirements.
What would be the RI with the new project?
RI = Net Income – (Investment × Required Minimum Rate of Return)
= Rs. 2,55,000 – (Rs.12,00,000 × 12%) = Rs.2,55,000 – Rs.l,44,000
= Rs.l,11,000

Use of the RI measure shows that by accepting the project, division’s RI

increases, which would provide incentive for Supermax division to accept the
new project. This is the desired result, since from the company point of view;
the project is worthwhile and hence should be accepted. This example
202 illustrates the primary advantage of RI measure compared to ROI measure.
Are there any disadvantages in using RI measure? It is often suggested that Investment Centres

ROI has an intuitive appeal to a manager, while residual income is more

abstract; it is an absolute figure and has less appeal. In real life situations and
business parlance, return percentages are often used and cited in many types
of investment and related matters, and are better understood. You might ask
the question: Is this advantage of ROI (disadvantage of RI) significant
enough to offset the advantage RI has and which was just illustrated?

Example 3

We will now again illustrate how the acquisition of new equipment is

affected under the two measures of ROI and RI. Suppose a business unit
‘Finemax’ acquires a new machine at a cost of Rs.2,00,000, and the machine
is estimated to produce cash savings of Rs.54,000 a year for five years. If the
company requires a return of 10 per cent, such an investment is attractive, as
shown by the calculations in section A of Table 7.3. The proposed investment
has net present value of Rs.4,800 and, therefore, should be undertaken.
However, if the machine is acquired, and if the business unit measures its
asset base as shown in the column ‘without machine’, the reported economic
value added of the unit in the first year will decrease, rather than increase.
The income statement without the machine, and the income statement if the
machine is acquired (and in its first year of use), are shown in section B of
Table 7.3. You will note that with the acquisition of the machine, income
before taxes has increased, but this increase is more than offset by the
increase in the capital charge. Thus, the EVA calculation indicates that the
profitability has decreased, whereas the real fact is that profits have
increased. In these circumstances, the unit manager may be reluctant to
purchase the machine.

Table 7.3: Incorrect Motivation for Asset Acquisition (Rs.000)

A. Economic Calculation: Rs. Rs (000)

Investment in machine 200
Cash flow, Rs.54,000 per year
Present value of cash inflow (Rs.54,000 × 3.791) 204.8
Net present value 4.8

B. Shown on Investment centre income statement

Without machine With machine

Revenue 200 200
Expenses, except depreciation 1700 1646
Depreciation 100 1800 140 1786
Income before taxes (EBT) 1200 214
Less capital charge at 10% 100 120
EVA 100 94
203
Management Note:
Control Structure
Cash inflow has been assumed to be net of income taxes

Rs.3.791 is the present value of Re.1 per year for five years at 10 per cent.

Capital charge on the new machine is calculated at its beginning book value,
which for the first year Rs.200 x 10% = 20. The beginning of the year book
value of the machine has been taken for simplicity, though average book
value could also be taken. The result will be similar.

In the later years, the EVA will increase, as the book value of the machine
declines. The EVA will increase from Rs.6,000 in year 1 to +Rs.l0,000 in
year 5. The increase in EVA each year does not represent economic change.
The increases appear to show that profitability is constantly improving,
whereas the facts are that there has been no real change in profitability after
the machine was acquired. Evidently, therefore, the unit managers in general
which have old fully depreciated assets will tend to report larger EVA than
units that have newer assets.

Table 7.4: Effect of Acquisition on Reported Annual Profits (Rs.000)

Book Value Incremental Capital EVA ROI

at Beginning Income* Charge*
of year
Year (a) (b) (c) (b-c) b/a
1 200 14 20 -6 7%
2 160 14 16 -2 9
3 120 14 12 2 12
4 80 14 8 6 18
5 40 14 4 10 35
Note: True return = approximately 11 per cent. *Rs.54,000 cash inflow- Rs.40,000 =
Rs.14,000. #10 per cent of beginning book value.

If profitability is measured by ROI, the same inconsistency exists, as shown

in the last column of Table 7.4. Although we know from the Present Value
calculations that the true return is about 11 per cent, the unit financial
statement reports that it is less than 10 per cent in the first two years, and then
it increases. Furthermore, the average of the five annual percentages shown is
16 per cent, which far exceeds, as we know what it is, the true annual return.

The practice both in USA and in India abundantly indicates that most
companies employ ROI, rather than RI or EVA, for evaluating financial
performance of their investment centres. To reiterate, there are three apparent
benefits of ROI measure. First, it is a comprehensive measure. Second, ROI
is easy to calculate, and is easy to understand, and meaningful in the
comparative sense. Third, it is a common denominator that may be applied to
any organizational unit responsible for profitability, irrespective of its size
and nature of business. Further ROI data is available for competitors which
204
can be used for comparison. Residual income is a less convenient measure Investment Centres

than ROI, It is an absolute number, not related with the size of the division.
Obviously, it is easier for a much larger division to earn a given amount of
residual income than a smaller division. The alternative is to calculate
residual income as a percentage of investment, but it is not a satisfactory
solution because it reintroduces the problem that ROI measure has and which
was eliminated by using residual income.

On the other hand, EVA has three points in its favour over ROI. First, with
EVA, all business units have the same objective for comparable investments
(we have seen and examined earlier that how ROI provides different
incentives for investment across business units). Second, where ROI falls
between the companies’ cut off rate and the actual ROI, the RI approach will
encourage the managers to undertake the investment. Third, different capital
charge rates may be used for different types of assets, depending upon risk
factor. Business assets can then be classified accordingly and different rates
applied for the purpose of measuring performance (this point, though, may
not be practiced by many companies). Generally, managers are reluctant to
make socially oriented investments that improve working conditions, reduce
pollution, or meet other social goals. These investments, from the strict
commercial sense, are not productive or sufficiently profit earning (at least in
the short-run). Such investments will become attractive if lower rates of
capital charge are levied on them.

Although RI solves the conceptual measurement problem of ROI, the

problem of appropriate investment base still remains. Therefore, residual
income may be used along with the Annuity Method of depreciation to solve
the problems of the investment base which we shall take up a little later. It
will suffice to say at this point that the simultaneous use of residual income
and annuity depreciation solves the problems encountered when ROI is used
to measure performance of investment centres.

To sum up, a firm that aims to design a measurement system for optimum
performance should use discounted cash flow method for project selection.
Once a project is selected, it is advisable to use the residual income method
as a measure of performance. Though the annuity method of depreciation is
somewhat problematic, a depreciation schedule may be worked out. If this
approach is adopted, then this will encourage investment centre managers to
undertake all investments that are deemed profitable from the firm’s point of
view and reject those that the firm would reject. This way, goal congruity will
be ensured for monitoring and evaluating investment centre performance. If
Annuity Method of depreciation somehow does not appeal to the
management (organisationally, the annuity method of system is quite
demanding), then net book value with residual income is the second best
option The subject of valuation of assets is discussed in a subsequent
section). The conclusion that emerges is:

Simple use of ROI as a measurement system with no adjustment for 205

Management investment base is likely to do more harm than good
Control Structure
A company using ROI, however, may not feel very much circumscribed if it
uses ROI carefully and does not give it the primary importance, and the
company also uses some other financial objective like budgeted profit goal.
Residual income as a method for measuring investment centre performance is
more advisable than the ROI, as the former overcomes the problems inherent
in the latter. It should also be noted that though RI is conceptually superior,
yet in actual practice it is the ROI whose use is more widespread because of
its innate appeal. In periods of inflation, replacement costs should be used
under the RI method.

Example 4

Calculate return on sales, asset turnover, return on investment, and residual

income from the following data:

Sales 80,00,000/-
Net book value (beginning) 25,00,000/-
Net book value(ending) 27,00,000/-
Net Income 5,40,000/-

Minimum rate of return 14%

Solution
Return on Sales = Profit/Sales × 100
= 540000/8000000 ×100
= 6.75%
Asset turnover= Sales/Average Assets
= 8000000/{(2500000+2700000)/2}
= 3.07 times

Profit Sales
Return on Investment= ————— × ————————
Sales Assets employed
= 6.75 × 3.07
= 20.76%
Residual Income = Operating income – (Minimum rate of return × Operating
assets)
= 540000 – (14% × 2600000)
= 540000 – 364000
= Rs.176,000/-
# Average assets= (Beginning Book value+ Ending Book value)/2

206
Example 5 Investment Centres

The following are the operating result of A Ltd. Calculate EVA assuming a
weighted average cost of capital at 8%, 10%, and 12%

Profit before interest and after-tax Rs.500,000/-

Fixed Assets Rs.32 lakhs
Working Capital Rs.18 lakhs

Solution:

EVA (Economic Value Added) = Post-tax Profit- (Weighted average cost of

capital ×Total capital employed)

8% 10% 12%
Profit 500000 500000 500000
Total Capital Employed 50,00,000 50,00,000 50,00,000
(Fixed assets + Working
Capital)
Weighted Average Cost of 8% × 50 lacs 10% × 50 12% × 50 lacs
Capital =400000 lacs = 600000
= 500000
EVA 100000 – (100000)

Example 6

Divisions M, P, and C of Little Lotus Limited are respectively engaged in

activities of Marketing, Manufacturing, and both. Control is through Return
on Investment. Fixed assets are depreciated on a straight-line basis assuming
an asset life of 10 years. The performance of the divisions is as follows:

(All figures in lakhs)

Div M Div P Div C

Profit before depreciation and operating 500 400 450
exp.
Current Assets 200 200 200
Fixed Assets nil 1000 500
Operating expenses 300 200 150

a) Compare ROI for each division

b) Analyse and comment on the relationship, if any, between ROI achieved
and divisional activities.

207
Management Solution:
Control Structure
Div M Div P Div C
Profit before depreciation and operating 500 400 450
exp.
Operating expenses 300 200 200
Depreciation (Straight line method over 0 1000/10 = 500/10
10 years) 100 = 50
Profit after Depreciation and Operating 200 100 200
Expenses
Current Assets 200 200 200
Fixed Assets nil 1000 500
Return on Investment 100% 9.09% 30.76%
Profit*100
(Total Assets less depreciation)

(b) Relationship between ROI and divisional activities

Division P which undertakes manufacturing activity has the least ROI

whereas, Division M which does only marketing activities reports the
maximum ROI. The reason is Division P employs more assets as compared
to Division M and Division C.

Therefore, when the activity requires heavy investment ROI will be relatively
less. However, ROI is not a measure of efficiency for Division M. This is
because service activities will deploy lesser assets and the ROI is not a true
measure of performance for such Divisions.

For Division C however, ROI is an ideal measure of performance since there

is sufficient deployment of assets.

Example 7

X company’s cost of capital is 12%

Div A Div B
Capital invested 2400 4000
Net Income 480 720
ROI 20% 18%
a) Which division is more profitable?
b) Suppose the Manager of Division A was offered a one-year project that
would increase the investment by Rs.1000 and generate a return of
Rs.150, would the manager accept the project if he were evaluated by the
ROI he generates for his division?
c) Would the decision taken by the manager be correct? Why/ Why not?
d) At what cost of capital will the Divisions be equally profitable?
208
Solution: Investment Centres

Division A generates a better ROI as compared to Division B.

However, if the EVA is calculated, then the results of the divisions would
appear as follows:

Division A Division B
Capital invested 3000 4000
Net Income 500 720
ROI 20% 18%
EVA 500-(3000*12%)=140 720-(4000*12%)=240

When EVA is compared, Division B’s performance is better.

If Division A is offered a project that would increase investment by

Rs.1,200/- and the income by Rs.200/- then the revised ROI will be as
follows:

Income = 500 + 200 = 700/-

Investment = 3000 + 1000 = 4,000/-
ROI = 700/4000 × 100 =17.5%

If the Divisional manager were evaluated by ROI he generated, he would not

accept the project.

The decision would be incorrect because the cost of capital is 12% and the
new project gives a return of 16.7% (200/1200*100). Since the cost of capital
is less than the return on the project, it should be accepted since it would
increase the profits of the business.

The Divisions would be equally profitable when the cost of capital is 15%.
This is explained as follows:
500 – (3000 × cost of capital) = 720 – (4000 × cost of capital)
– (3000 – cost of capital) + (4000 × cost of capital) = 220
1000 × cost of capital = 220
Cost of Capital = 220/1000 = 0.22 or 22%

What is the difference between residual income and Economic value-added?

7.9 MEASURING INVESTMENT BASE

The choice of asset base for assessing the performance of the investment
center could be tangible and/or intangible assets, controllable uncontrollable
and/or partially controllable assets, total assets and/or total assets minus
liabilities, etc. Each of these will have the effect of changing the ROI.
Similarly, the asset value could be gross block or net block, book value or
market value or replacement value, etc.
209
Management When the gross block of assets is used to calculate ROI, then the choice of
Control Structure
method of depreciation does not affect the ROI.

When the net value of assets is used in the base to calculate ROI, it might
result in using a higher rate of depreciation or quick write-off of asset values
resulting in high ROI. If a Division operates with old equipment and written-
off assets that need to be replaced shortly, then the Replacement value of
assets can be used to calculate ROI.

The sum of the assets employed is termed the investment base. In deciding
the investment base to be used for evaluating the performance of investment
centres, the corporate management would be concerned with two questions:
(i)What practices will induce business unit managers to use their assets more
efficiently and to acquire new assets of proper kind and proper investment?
Although it is natural for the investment centre managers to improve their
performance in terms of the measure adopted, corporate management would
want the actions of the investment centre managers fall in line with the
interests of the company as a whole; and
(ii)What practices would best measure the performance of the units as
economic
entities?
There are several questions of importance in the measurement of the
investment of the divisions or investment centres, and in particular, they
relate to:
• Definition of invested capital (what items to included and at what
value?);
• Assignment of central office assets to divisions; and
• The effect of price level changes.

The problem in relation to definition of invested capital is twofold: the first

question relates to what items are to be included or excluded from the
investment base for a division/ investment centre. Once the items to be
included are decided, the second question is the valuation method to be used
in assigning an amount to each of these items. The problem of defining
invested capital is interwoven with the valuation of long-term assets. Another
issue, though minor one, is whether to use start-of the-period, average, or
end-of the-period values of assets. Since income is usually earned and
measured continuously throughout the year, it is probably best to use average
level of assets during the year/ period.

What is to be included in investment?

In determining what assets to include in an investment centre’s investment

base, we must decide whether the primary purpose is to measure the
performance of the division or that of the division manager. If the purpose is
to evaluate the divisional manager, then only those assets that are directly
210 traceable to the division and controlled by the division manager should be
included in the investment base. Corporate assets used by the central Investment Centres

administration or assets controlled at the central level, such as cash, that are
neither directly traceable nor controllable at the divisional level should be
excluded from the point of view of the evaluation of the divisional manager.
The major consideration in what should be included in the investment base is
controllability. Items which are controllable by the manager should be
included so that his attention and motivation is directed towards the control
of such items.

The corporate management may also be interested, as we shall see later, in

evaluating a division’s economic performance and in comparing it with
similar firms outside in the same industry. Looked from this angle, an
evaluation based solely on controllable investment overstates the division’s
actual profitability. The overstatement occurs because no division could
operate without the services represented by corporate assets (such as
buildings and furnishings for senior executives and corporate staff
departments, and cash and some other assets managed at the corporate level).

The argument against including assets which cannot be significantly

controlled is that it directs investment centre manager’s attention to non-
controllable events and thereby wastes manager’s time. The counter-
argument also looks persuasive, and it relates to how management must
establish the target ROI or RI. Both ROI and RI require the selection of a
satisfactory percentage return. How is this derived? As in the determination
of target profit for a division, examination of the percentage achieved in the
past with an observation of the percentage being achieved currently by the
competitors is relevant. The comparison with past performance is not difficult
if the company has maintained consistent records. Comparison with
competitors may present difficulties, and depends how sufficient or usable
the comparative figures are from company’s management control point of
view. In conclusion, it may be said that investment should be defined as total
assets in most cases, and if this is not feasible then the company should not
use the investment centre idea.

A number of asset items may be uncontrollable by the division manager. Let

us examine some such assets and their position vis-a-vis their inclusion in the
investment base. Cash: In most situations cash is managed by the central
office or corporate treasurer. The cheques are paid to and paid by the central
office. The division manager may have a small fund to use for payments or a
“float” which is roughly equal to the difference between daily receipts and
daily disbursements. Controlling cash at corporate headquarters is found
more efficient because the demands of many divisions may be balanced at
minimum capital.

Since divisions rarely have separate bank accounts. If cash is to be included

in investment, it may either be some notional amount (say, Rs.2 lakhs) or a
percentage of sales or some other estimate of amount of cash that a division
would have to maintain if it were an independent company. The percentage 211
Management of sales is used on the assumption that greater the volume of operations, the
Control Structure
greater the cash required. Many companies calculate the cash to be included
in the investment base by means of a formula. For example, General Motors
(of USA) is reported to use 4.5 per cent of annual sales.

Accounts receivable: Accounts receivable are also often uncontrollable at

the divisional level. The main points of control in accounts receivable are
credit approval, billing and collection of the accounts. If all the three points
of control, i.e., credit approval, billing and collection are centralized (for the
reason that central collection leads to fastest possible receipt by the corporate
treasurer), then division managers hardly have any control on accounts
receivable. In such cases, receivables may be calculated on a formula basis,
instead of actual receivables. But, it all depends on what practice the
corporate management has evolved for the divisions. Some companies may
like to decentralize this operation, in which case the unit managers are able to
influence directly by establishing credit terms, approving individual credit
limits, and by vigorously collecting overdue receivables. In that case the
accounts receivable would usually be included at the actual amount. Even if
the billing and collection is done at corporate headquarters, it is argued that
sales are identifiable with various divisions.

Inventory: Inventory control may be limited by central purchasing activities.

If many divisions make use of the same raw materials, central purchases of
large quantities may be more efficient than separate purchases being made by
divisions. Inventories are most often included at book value unless the
company uses “last in, first out’ (LIFO) inventory method. If the company
uses LIFO for financial accounting purposes, and the same method is used for
unit profit reporting, inventory balances tend to be low in periods of inflation
(if prices have consistently been rising). In these circumstances, inventory
should be valued at standard or average costs or replacement cost, and these
same costs should be used to measure cost of sales in the unit income
statement.

Working capital in general: Considerable variation in how working capital

items are treated may be found in actual practice. At one extreme, companies
include all current assets with no offset for any current liabilities. At the other
extreme, all current liabilities may be deducted from current assets. There are
arguments on both sides. As for major capital expenditures, most
organisations require central approval. However, some companies may give
division managers the authority to make limited capital expenditures without
prior corporate approval. In some cases, corporate approval is necessary prior
to sale of a long-term asset. Before the asset is sold, it may be necessary to
offer it to other divisions of the company at a reasonable or negotiated price.
Though division managers often have restrictive control on long-term assets,
they often can exert significant control on the investment in long-term assets.

Leased assets: A related problem with long-term assets is accounting for

212
leased assets. Financial Accounting standards require that certain types of Investment Centres

leases be capitalized and accounted for assets, but some others may not be
treated this way. If the percentage of leased assets varies from division to
division, it may create difficulties in comparisons. It is generally believed that
all long-term leases should be capitalized for consistent practice.

If all the restrictions on control of assets described in the preceding

paragraphs have to exist (i.e., no assets are genuinely controllable) for a
particular unit, there is a strong case for arguing that the control of
investment is so weak that a profit centre idea would be more appropriate
than an investment centre one. Investment centre would have a real appeal
where all assets are controllable by the manager, and in such a situation total
assets for determining investment (which is discussed in the next section)
may be used.

Defining invested capital

Some important ways in which divisional investment could be defined are:
Division’s share of shareholders ‘equity,
Total assets, and
Net investment.

Shareholders’ equity represents the book value of the owners’ investment of

the assets of the firm and centres attention on the interest of the owners.
Though important to the owners, this definition is not so significant to the
operating managers who are usually concerned with the utilization and
management of assets rather than with the long-term sources of finance for
assets. Ordinarily, investment in the divisions cannot be identified
specifically with any particular component of capital or funds. The capital
mix is a characteristic of the company as a whole. Division management is
entrusted with a portion of the company’s total capital from its pool of funds
which consists of both equity and debt and retained earnings, and any
distinction at the divisional level is unnecessary. To an investment centre, the
total amount of the funds is relevant, but the sources from where they were
obtained are not relevant.

Division managers rarely have authority to incur long-term debt without prior
corporate approval. Thus the principle of controllability argues against
subtracting long-term debt in determining investment. Subtracting short-term
debt from total assets to determine investment would mean that a division
manager could reduce investment and thereby improve ROI or RI by building
up short-term debt, by slow payment of accounts, and by inappropriate level
of short-term borrowing. So, while managers might have some control over
short-term debt; its inclusion could tend to direct them toward actions that
may not be in the best corporate interest.

For measuring performance of investment centres, any one of the two other
methods is considered better than the shareholders’ equity. The total assets
213
Management method considers the aggregate of all assets-fixed and current- without
Control Structure
considering current liabilities. The assets mean the assets available for use or
actually employed by the division. If, under instructions of the top
management, division managers are required to carry some extra assets that
are not currently productive and they form a sizeable part of the assets
available, then such assets should be deducted from computing the assets
employed. The exclusion of such assets would naturally push up the ROI or
RI, as the case may be.

Net investment, i. e., fixed assets plus net working capital, means exclusion
of that portion of the current assets which is supplied by short-term creditors.
The main justification for this base is that managers often have direct
influence over the amount of short-term credit. If they have this control, this
base is advisable. Except for the treatment of current liabilities, there is no
difference between ‘total assets’ and net investment bases. Of the two, net
investment is more closely comparable to the (book) cost of capital figures
because it includes only those funds that are provided to the firm specifically
for interest-like return, i.e., owners’ equity, long term debt, and debt bearing
short-term interest.

Example 8
Namo Enterprises Limited operates some of its divisions as Investment
Centers and accordingly their performance is measured by the ROI that they
generate.
Division R has an average investment of Rs.1,00,00,000 presently. This is
not expected to change for the next 4 years.
The Division is currently operating on fairly old assets, some of which are
run down and nearing the end of useful life.
Replacement of such assets is expected to cost the Division an additional
capital investment of Rs.30,00,000 at the beginning of the year 2011.
Additional cash flow on account of savings in maintenance and enhanced
productivity is expected to be Rs.10,00,000 every year for the next 5 years
before tax. The company uses the sum of year digit method to provide
depreciation of the asset for income tax purposes.
The cash flows and income statement of the Division appear as follows:

Particulars Current After

Replacement(Projected)
Income from investment 10,00,000 20,00,000
Depreciation( On new asset) - 10,00,000
Net Income (after adjusting 10,00,000 10,00,000
50% tax)
Investment(Net) 1,00,00,000 1,20,00,000
ROI (Calculated on EBIT) 10% 8.33%

214 On seeing the calculations as above, the Division manager is not too keen to
work with new assets; there are talks of meltdown and downsizing all around Investment Centres

and he was not willing to take flak for lower ROI. He had his bonus at stake
and therefore he decided not to press for any asset replacement.

Required:

Assuming a cost of capital of 10%, is the Division manager justified in

deciding not to replace the assets? Assume a 50% tax rate.

Suggest any two performance incentives that may incentivize managers to

take decisions that are economically feasible in the wake of falling ROI.

Solution:

Note:

1. At a cost of capital of 10% the inflows amount to Rs.31,04,607 which is

more than the investment of Rs.30,00,000/- Therefore the manager is not
justified in rejecting the purchase of assets.
2. a. Managers can be incentivized on capital purchases which result in
cash flows in excess of cost of capital.
b. Managers can be incentivized for identifying the best opportunities
to increase cash flow rather than on the ROI.

When land and building are eliminated from assets, then in such cases return
is calculated without reference to a place of operation and therefore there
would be no incentive for Divisions operating out of backward areas or
relatively underdeveloped areas. Also including land and building in the asset
base may have the effect of pulling down the return of divisions that have a
high cost of real estate.

Cash flow Dep Profit/ Profit Depreciation Present

Loss after tax adjusted value at
Cash flow 10%
Outflow - 30 00 000
(year o)
Inflow- 10 00 000 10 00 000 10 00 000 9 09 091
Year 1
Year 2 10 00 000 8 00 000 2 00 000 1 00 000 9 00 000 7 43 802
Year 3 10 00 000 6 00 000 4 00 000 2 00 000 8 00 000 6 01 052
Year 4 10 00 000 4 00 000 6 00 000 3 00 000 7 00 000 4 78 109
Year 5 10 00 000 2 00 000 8 00 000 4 00 000 6 00 000 3 72 553
31 04 607

Note:

At a cost of capital of 10% the inflows amount to Rs.31,04,607 which is

more than the investment of Rs.30,00,000/- Therefore the manager is not
justified in rejecting the purchase of assets.

a. Managers can be incentivized on capital purchases which result in cash

flows in excess of cost of capital.
215
Management b. Managers can be incentivized for identifying the best opportunities to
Control Structure
increase cash flow rather than on the ROI.

When land and building are eliminated from assets, then in such cases return
is calculated without reference to a place of operation and therefore there
would be no incentive for Divisions operating out of backward areas or
relatively underdeveloped areas. Also including land and building in the asset
base may have the effect of pulling down the return of divisions that have a
high cost of real estate.

7.10 ALLOCATION OF CENTRAL OFFICE ASSETS

A related question with what items are to be included in the investment base
is the question relating to whether central office assets are to be allocated,
and if they are to be allocated, then what should be the basis applied?

There are always some assets or facilities located at the central or corporate
level for the reasons discussed in Unit 5. A distinction should be drawn
between assets or facilities which are common to a few (that is, shared
between two or more) divisions and those which are truly common to all the
divisions.

Many of the assets in some companies and some of the assets in all
companies may be directly identified or traced to particular divisions. It may
not be quite uncommon to find some assets in the central office as directly
relevant to particular divisions. Company cash requirements, for example,
bear some relationship to the size and structure of divisional operations even
where cash is centrally administered. Traceability of assets is considerably
facilitated where the company is engaged in diverse activities. From the
economic standpoint, it has been stressed that the relevant investment base is
the amount that is uniquely devoted to support a division’s operations, and
from the traceability point of view the criterion that satisfies this definition is
the “criterion of avoid ability,” i.e., what portion of the central office assets
would be unnecessary of this division was not present.4 Efforts should be
made to reduce non-traceable assets to the minimum. As “traceable
investment” is regarded as close to “controllable investment”, it is a better
measure for control purposes.

The various bases used by companies to allocate central office assets are:
sales revenue, number of employees, services availed, conversion cost, or
some adhoc percentages. In order that allocations are not arbitrary,
statistical analysis should be attempted to reveal usable relationships. Though
these allocations add nothing to the ability of the performance index to reflect
the profitability of the divisions’ assets, they, however, represent the desire of
the top management to make divisional ROI roughly correspond to company-
wide ratios. Where divisions are engaged in identical industrial activity and
hence valid comparisons are practicable, allocation of central office assets
should be made in such a manner that procedure does not affect
216
divisional ranking. One way to accomplish this is to distribute non-traceable Investment Centres

common assets as a uniform percentage of the investment reasonably

attributable to divisions. This will have the effect of reducing all ratios
proportionately and leave the relative ranking undisturbed. However, the
bases commonly adopted for allocating central office assets (including
common R&D) show that ‘capacity to bear’ influences the decision more
than any other factor.

In a study in India, while all the respondents included receivables and

inventories in the determination of investment base, 73 per cent and 85 per
cent included cash and other current assets. Only 15 per cent of the
respondents were found to be allocating central/corporate office assets to the
investment centres and included them in the investment base.5

7.11 ASSET VALUATION ALTERNATIVES

Having explained what assets should be included or excluded from the
computation of investment base, we now take up the second aspect in relation
to determination or defining the investment base; to be more precise, how
should the fixed assets be valued for the purpose of determining investment
base? Fixed assets, e.g., plant and machinery is an area where there are
significant measurement difficulties. First, since these assets are long-lived,
there is a strong likelihood that their economic value may differ significantly
from their historical cost as shown in the accounting records. Replacement
cost is the most often advocated as a means of adjusting the historical costs;
but is rarely practiced, as we have examined elsewhere in this unit. Should
they be measured at gross book value, net book value, replacement cost, or
realizable value (scrap or salvage value), or some other basis?

Gross Book Value vs. Net Book Value

In financial accounting, as you might be aware, fixed assets are initially

recorded at their acquisition cost, and this cost is written off over the asset’s
useful life through depreciation. Most companies use this or a similar
approach in measuring asset base of the investment centre. The two methods
Gross Book Value and Net Book Value are variants of the historical cost
basis. Whereas in the Gross Book Value method the assets are shown at
original cost or undepreciated values, in the Net Book Value method the
assets are shown at depreciated values, i.e., original cost minus depreciation
to date.

There are arguments for and against each of the above two methods. Net
book value is often favoured because it corresponds with the amounts shown
in the published annual accounts and the usual accounting reporting. But the
use of net book value introduces certain biases into the computation of ROI
and RI. We will briefly discuss their arguments and counter-arguments.

Let us first look at the Net Book Value side of the story and see what
arguments have been advanced for and against. 217
Management • It has been stated that if earning power is not steady but declines as
Control Structure
facilities age, Net Book Value will provide a better measure for internal
ROI comparisons.
• If depreciation charge can be taken to reflect, as it should, the patterns of
expiration of service potential, then net book value is obviously less
confusing because it is consistent with the values shown in the balance
sheet for external reporting. It is also consistent with the net profit
computation which includes a deduction for depreciation.
• It has been asserted that the use of gross book value is perhaps an over-
reaction to problems caused by use of net book value method and
straight-line depreciation to compute the ROI. While eliminating some
distortions, it introduces new problems.
• If assets are included in the investment base at their original cost, then
the division manager may be motivated to get rid of them, even if they
have some useful life left because the division investment will be
reduced by the full (or original) Cost of asset. Even marginal
replacement decisions might appear attractive. The investment might be
unattractive to corporate management, but would be attractive to division
manager for it has good effect on his ROI. Thus, an investment proposal
which is unsatisfactory from the corporate point of view might be
pressed by the division manager because it would increase his ROI. If the
company uses accelerated depreciation instead of straight-line method,
the effects of these differences would be magnified.
The other side of the story also appears equally appealing. The main
arguments advanced in favour of Gross Asset approach (and against the Net
Book Value approach) are:
• Intra-company differences in depreciation policy, affecting the
investment base and the performance index may impair the validity of
intra-company comparisons since depreciation allowances are deducted
from asset values.
• Intra-company comparisons are adversely affected due to year-after-year
differences in the age of depreciating facilities/assets. The older divisions
with large accumulated depreciation will have in-built advantages. If
earning power does not decline with age, the net book value approach
will tend to lower the younger division’s position in inter-divisional
ranking. Further, as the division gets older, its net book value will
decline in relation to original cost and it will show an upward trend of
ROI which is logically indefensible. For this reason, several large and
well known companies in the USA like DuPont and Monsanto use Gross
Book Value as a measure of their fixed assets in computing ROI.
• The Gross Value method practically compensates for inflation not
reflected in historical cost. (However, from this standpoint, Gross Book
Value method may not be a reliable means of approximating replacement
cost/value; it will just be a compromise).

218 Let us now dispassionately examine these arguments.

A glaring drawback of the Net Book Value method is that investment shows Investment Centres
an increasing trend of ROI as the asset ages. The investment centre buys a
machine at the beginning of the year at a cost of Rs.2,00,000 on which
depreciation on straight- line basis is to be provided over five-year-period.
Assume that the asset will generate a constant net income of Rs.20,000 a year
throughout its life. Assuming also that the asset will have no scrap value at
the end of five years, the annual depreciation will be Rs.40,000. The
calculations are shown in Table 7.5. As shown in the last column of the
Table, the ROI on the asset increases from 12.5 per cent in the first year to
100 per cent in the last year. Towards the end of the 5th year, with all the cost
of asset written off, no net book value is left, and hence a return of 100 per
cent.

Table 7.5: Net Book Value (with Straight-Line Depreciation) and ROI

Original Annual Accumulated Net Book Annual ROI

Cost* Depreciation Depreciation Value Net %
Income
2,00,000 40,000 40,000 1,60,000 20,000 12.5
2,00,000 40,000 80,000 1,20,000 20,000 16.7
2,00,000 40,000 1,20,000 80,000 20,000 25.0
2,00,000 40,000 80,000 40,000 20,000 50.0
2,00,000 40,000 40,000 0 20,000 100.0

Note:
Life of the asset has been assumed to be five years, with no scrap value.

Another important bias of Net Book Value is that it makes less attractive the
replacement of old equipment which has depreciated to a low net value, in
spite of the fact that new equipment may offer much savings in expenses. The
replacement of old equipment may increase the investment significantly (if
the net book value of the old equipment is rather low and the cost of new
equipment is high).

Table 7.6: Asset Balances

Cash Rs.20,000
Accounts receivable 40,000
Inventories 30,000
Plant and equipment, net book value 1,10,000*
Total Assets 2,00,000

Note:
Original cost is Rs.1,80,000.

Table 7.6 above portrays Attramax’s (a division of a company) average asset

balances for a year based on net book value. The Profit & Loss Account (or
income statement) of the division shows net income by the division for the
219
Management year to be Rs.40,000. Thus Cost The ROI is 20 per cent.
Control Structure
Net Income 40,000
ROI = = ---------------------------------- = ----------------- = 20%
Book Value of Total Assets 2,00,000

The corporate minimum expected rate of return is 22 per cent for new
investments (but ROI is not an accurate method of evaluating capital
expenditures, the present value or DCF techniques are better and should be
used, as we have indicated later).A major renovation of plant and equipment
has been proposed at a cost of Rs.2,40,000. The capital expenditure promises
additional net cash flows of Rs.62,000 per year over its expected ten-year
life. In the process of renovation, equipment with an original cost of
Rs.60,000 whose present net book value is Rs.20,000, and whose annual
depreciation is Rs.2,000 would be replaced. Company analysts have
calculated the present value rate of return on this investment to be about 24
per cent. Assuming that the investment looks attractive to corporate
management, what would be the effect on ROI?

The net book value of the total assets is Rs.2,00,000 minus the Rs.20,000 net
book value of the old equipment, plus Rs.2,40,000cost of the new assets, a
total of Rs.4,20,000 (the new equipment might be included at its original cost
less one-half year’s depreciation to provide an average net book value for the
first year. If this refinement makes any important difference, the calculations
could be revised).

Suppose that all other expenses and revenues of the next year’s operations
remain unchanged from last year, except for the changes related to the
renovation. With this assumption, the new net income can be calculated. Last
year’s net income would be augmented by Rs.62,000 net cash flow generated
by the plant and equipment renovation, plus Rs.2,000depreciation to be
avoided on the old equipment disposed of, less additional depreciation on the
renovation of Rs.24,000 (assuming Rs.2,40,000 is depreciated over ten years,
and there is no scrap value). The new net income would, therefore, be
Rs.80,000 (Rs.40,000 + Rs.62,000 + Rs.2,000-Rs.24,000). The revised ROI
becomes:

Net Income Rs. 80,000 = 19% ROI =

Book Value of Total Assets Rs. 4,20,000 (approx.)

Corporate management would like the division manager to propose this

capital expenditure because the present value rate of return exceeds the
minimum rate of return required of 22 per cent. The immediate effect,
however, is the reduction in the reported ROI from 20 per cent to 19 per cent,
making the division manager’s performance appear slightly poorer. This
situation might discourage the division manager to initiate renovation effort
even though it is in the interest of the corporation. What would you do, if you
were the division manager? Keeping the basic data of Table 7.6 in view, what
would be the ROI for the division say at the end of 7th year after
220
renovation? Make your calculations to see if it results in more important bias. Investment Centres

Does it happen so?

Since the problem is not with the numerator, but it is with denominator of the
ROI equation, the use of gross book value would avoid the decline in the
denominator and solve the problem. The average asset balances for a year
based on gross book value (same basic data used Table 7.6) will be
Rs.2,70,000. Existing net income for the division is Rs.40,000. The ROI,
therefore, is 14.8 per cent as under:

Net Income Rs. 40,000

ROI = = 14.8%
Gross Book Value of Assets Rs. 2,70,000

ROI is lower than what was calculated using net book values (20 per cent)
because the asset base in the denominator includes the plant and equipment at
its gross book value (Rs.20,000 + Rs.40,000 + Rs.30,000 + Rs.1,80,000). If,
however, the company consistently follows the policy of using gross book
values, and the target ROI is adjusted accordingly, no one would be
concerned over the difference in ROI produced by the two methods.

The fluctuation in the EVA and the ROI from year to year as we had seen in
Table 7.4 can be avoided by including depreciable assets in the investment
base at gross book value rather than at net book value. If this was done, the
investment each year would be Rs,2,00,000 (original cost), and the additional
income would be Rs.14,000(Rs.54,000 cash flow - Rs.40,000 depreciation).
The EVA, however, would be decreased by Rs.6,000 (Rs.14,000- Rs.20,000
capital charge) and the ROI would be 7 per cent (Rs.14,000 divided by
Rs.2,00,000).Both of these numbers indicate that the business unit’s
profitability has decreased, which, in fact, is not the case. ROI calculated on
gross book value always understates the true return.

Whether the earning power of the assets increases or declines is often a

difficult question to answer. The main objective of providing depreciation
with respect is the recovery of capital, and the capital recovered through
operations is ordinarily reinvested in the business. Hence, the investment
base as a whole is not supposed to shrink and there will be no tendency for
return on net book value of assets to rise. An implication of this argument is
that if the capital recovered from a division operation is not reinvested in the
same division, but in some other division, then the declining net asset base
will cause the rate of return to increase. It is not necessary that the surpluses
generated by a division must be reinvested in the same division. The overall
strategy of the corporate management, among other factors, has a bearing on
the decision.

The arguments in favour of Gross Book Value method rest on the assumption
that the earning power of the asset is fairly constant from year to year, or to
put it differently, the earning power declines less rapidly than does the net
book value. However, if the division has a mixture of assets- old and new - or 221
Management the assets are well seasoned in age, the overall rate will not be unduly
Control Structure
overstated.

The main argument in favour of Gross Book Value method that intra-
company comparisons get distorted due to differing depreciation policies
followed by different divisions and also due to differences in the age of assets
are a bit exaggerated. Firstly, because the performances of the divisions of a
highly diverse company, in fact, may not be comparable; and secondly,
division managers may have no discretion to pursue independent depreciation
policies. The companies, in general, follow a uniform policy with regard to
depreciation for all divisions. Though the corporate management would
certainly be interested in monitoring the progress and performance of the
divisions, they need not necessarily compare the performances. That all the
divisions of the company in the long run should earn a return higher than the
cut off rate (opportunity cost) laid down by the corporate management is
what matters or should matter to the latter.

The limitations of straight-line method are also apparent when RI method is

used, though the effects are less dramatic than the ROI measure.

The effect of the differences that we have examined in Table 7.4 may be
neutralized in the ordinary situation if the company continually replaces
equipment. The equipment or machinery may be in all stages of life, and the
ROI is an average of many different life spans. Further, several more or less
unrelated economic changes occur which may make it difficult to see the
tendencies that we have discussed. It may be acceptable to use Net Book
Value for measuring the investment base in those companies where
investment decisions rest with the investment centre managers or where they
wield considerable influence on such decisions.

Annuity Depreciation

Annuity depreciation, in fact, is the present value depreciation and is derived

from discounted cash flow approach. When an asset yields level cash flows
over its useful life, the present value depreciation method is identical to the
annuity depreciation method. If the internal rate of return (IRR) of the asset
and the cash flows are equal over the life of the asset, then the accounting
rate of return (ROI) with annuity depreciation will be equal to the internal
rate of return (IRR) each year.

If annuity method of depreciation is used, instead of the straight-line method,

the calculations of the profitability of investment centres will show correct
EVA and ROI, as demonstrated in Table 7.7 and 7.8. This is because the
annuity depreciation method actually matches the recovery of investment that
is implicit in the present value calculations. Under the annuity depreciation,
the annual depreciation is low in the early years when the investment values
are high and increases each year as the investment decreases (something that
looks odd, though); the ROI remains constant.
222
The annuity calculations are shown in Table 7.7 and 7.8 with cash flows the Investment Centres

same amount each year. Equations are available through which depreciation
can be derived for other cash flow patterns, such as decreasing cash flow (as
repairs cost increase) or an increasing cash flow as a new product gains
market acceptance (when it is in the growth stage of life cycle).

Table 7.7: Profitability using Annuity Depreciation (Smoothing EVA) (Rs.000)

Year Beginning Cash EVA* Capital Depreciation$

Book value Inflow Charge#
1 200.00 54.0 1.2 20.0 32.80
2 167.20 54.0 1.2 16.8 36.00
3 131.20 54.0 1.2 13.2 39.60
4 91.60 54.0 1.2 9.2 43.60
5 48.00 54.0 1.2 4.8 48.00
Total 270.0 6.0 64.0 200.00
Notes:
Annuity depreciation makes the EVA the same amount each year by changing the amount of
depreciation charged. Consequently, the total EVS must be estimated over the five years. A
10 per cent return on Rs.2,00,000 would require five annual cash flows of Rs.52,756. The
actual cash inflows are Rs.54,000. Therefore, the EVA (the amount in excess of Rs.52,756)
is Rs.1,244.
#This is 10 per cent of the balance at the beginning of the year.
$ Depreciation is the amount required to make the EVA(profits after the capital charge and
depreciation) equal Rs.1,244 per year (rounded here to Rs.1200). This is calculated as
follows:
Rs.54,000-Capital charge-Depreciation = Rs.1,200
Therefore, Depreciation = 52,756-Capital charge.

Table 7.8: Profitability Using Annuity Depreciation (Smoothing ROI) (Rs.000)

Year Beginning Cash Net Depreciation# Return on

Book Inflow Profit* Beginning
Balance Investment
1 200.00 54.0 22.0 32.0 11%
2 168.0 54.0 18.4 35.6 11
3 132.4 54.0 14.6 39.4 11
4 83.0 54.0 10.2 43.8 11
5 49.2 54.0 4.8 49.2 10
Total 270.0 70.0 200.0 10%
Notes:
A return of Rs.54,000 a year for five years on an investment of Rs.2,00,000 provides a return
of approximately 11 per cent on the beginning of the year investment. Consequently, in order
to have a constant 11 per cent return each year, the net profit must equal 11 of the beginning
of the year investment.
# Depreciation is the difference between the cash flow and the net profits.
$The difference results because the return is not exactly 11 per cent.

As already hinted, managers find it rather odd that the depreciation allowance
should increase as the asset ages. Depreciation is generally visualized as
representing physical deterioration or loss in economic value. The managers
believe that straight-line depreciation is a more valid representation of reality. 223
Management As such, the Annuity Method, by and large, fails to convince the managers.
Control Structure
Further, annuity method presents some practical problems. If the actual cash
flow pattern differs from what is assumed for initial calculations (even
though the total cash flow might result in the same rate of return), some years
would show higher than expected profits and others would show lower. It is
not practicable to change depreciation schedule every year to conform to the
actual pattern of cash flow. Because of practical difficulties, probably,
companies do not use this method, neither for financial accounting nor for
management control purposes.

7.12 REPLACEMENT COSTS (HISTORICAL VS.

REPLACEMENT COSTS)
It is well known that purchasing power of money has been declining over
time. The higher the rate of inflation, the lower is the value of money. It has,
therefore, been asserted that performance index would be misleading if the
effect of inflation or price level changes is not neutralized. The main reason
for the distortion that occurs is that while revenues and (cash) costs are
measured in current values, the investment and depreciation charges are
measured on the basis of historical costs (used to acquire assets).

Depreciation based on historical cost underestimates what depreciation

charge would be if based on current costs. This causes the income of the firm
to be overstated. At the same time, investment of the firm is also understated
because most of the firm’s assets were acquired in previous years at lower
price levels than those currently prevailing. The combination of
overstatement of net income and understatement of investment causes the
ROI or RJ measure to be much higher than if inflation had not occurred.

An implication of inflation is that divisions with newer assets will tend to

show lower ROI and RI than other equally profitable divisions whose assets
were acquired at lower price levels (ignoring the effects of productivity or
quality improvements embedded in the newer assets).

A fundamental rule for making comparisons about the productivity of assets

is that measurement basis be uniform, that is, assets producing same net cash
flows with the same risk should have the same values. It has, therefore, been
asserted that the relevant investment measure for performance evaluation is
replacement cost, because it provides a common denominator representing
the equivalent of what would have been the required investment at the
beginning of any given period.

The main argument of the proponents of Replacement Cost theory in support

of their theory is:

While some divisions may be old, some may be new. Some divisions may
have been started, expanded at different points of time. Divisions with older
asset mix will have a lower investment base in terms of historical cost and
224
lower charges for depreciation, giving them dual benefit. Younger divisions, Investment Centres

relatively, will tend to report lower returns, especially if they were

established when price level had sufficiently escalated. It is quite likely that
the profitability of older divisions may mask the deteriorating profit situation.
The real situations would not be revealed unless the adjustment in assets for
price level changes is made.

This argument is countered by those who are not in favour of Replacement

Costs. It is contended that the market value or replacement cost for the assets
already in use may not exist, except probably for equipment. The proponents
of Replacement Cost theory, however, suggest that what is required is not the
current market value of the assets but values that would approximate the cost
of similarly used assets which would produce the same expected operating
cash flows as the existing assets. Therefore, the crucial factor, they say, is its
expected cash flow and not its physical or technological features. For
example, it has been suggested that inventories be valued at current standard
cost and long-lived assets at some approximation to current replacement cost
by use of explicit index numbers.

The above argument, though it sounds reasonable, is difficult to put into

practice. As equipment gets more advanced and highly specialized with rapid
technological changes leading to quicker obsolescence, the task of
approximating replacement cost becomes trickier. Though equipment indexes
may be available, still they may be far from providing objective bases for its
useful application in particular cases.

Some companies may use approximation of current values of assets. They

arrive at this amount by a periodic appraisal of assets, say every five years, or
when a new unit manager takes over, by adjusting original cost by an index
of price level change in the equipment prices.

A major problem with non-accounting values (such as replacement costs) is

that they tend to be subjective, as contrasted with accounting values, which
are generally seen as objective, and not subject to argument. Further, non-
accounting values are seen as inconsistent with corporate profitability as
reported to external stakeholders. Although the management control system
need not necessarily be consistent with external financial reporting, an
internal system that uses a different method is not viewed favourably,
notwithstanding its theoretical merit.

The problem of the impact of inflation is in no way different from the more
general problem in external financial reporting. Though some plausible
methods have been suggested in accounting literature for dealing with the
problem created by inflation, the subject is still in the melting pot. Though
some companies do bring out their price adjusted Annual Accounts or
financial statements (Balance Sheets and Profit & Loss Accounts) on a
supplementary basis, the practice has not gained much momentum. The few
companies that publish inflation-adjusted Annual Accounts do so are
225
Management prompted more by considerations of their corporate image and public
Control Structure
relations.

Asset Valuation and Related Practices

As shown in Tables 7.9 and 7.10, a large number of companies in the USA
and India use net book value as a valuation alternative for the purpose of
inclusion in the investment base which is in line with the practice for external
reporting. Perhaps, it seems that managements recognize the fact that this
method gives misleading signals, they seem to believe that the users of
business unit reports would interpret them after making due allowances.
Further, they believe that the alternative methods are too subjective to be
trusted. The real world seems to be aware of the pitfalls and limitations of the
measures and believe that no measurement is perfect. Simplicity and
practicality seem to lead many companies to use a less than theoretically
ideal measure.

Table 7.9: Valuation of Plant and Equipment -Practices in USA

Method Percentage of Respondents Using the Method

Study 1 (1978) Study 2 (1994)
Cross Book Value 14% 6%
Net Book Value 84 93
Replacement Cost 2 1
Source:
Study 1: Reece, James S. and Cool, William R., Measuring Investment Centre
Performance, Harvard Business Review, May-June 1978, pp.28-49.
Study 2: Govindarajan, V., cited in Anthony and Govindarajan V., Management Control
Systems, Tata McGraw-Hill, 1998, p.267.

An overwhelmingly large number of respondents in India, as shown in the

Table 7.10 defined investment base in terms of Net Investment. While
establishing ROI targets, the study revealed that large number of companies
established ROI targets in advance, and further, ROI targets were assigned on
individual basis which rested on the profit potential of various investment
centres. This indicates that companies follow a

Table 7.10: Investment Centres - Practices in India Investment Centres

A. How Respondents Defined Investment Base Percentage

Total Assets 4
Net Investment 92
No answer 4
Total 100
B. Valuation of Fixed Assets
Gross Book Value 8
Net Book Value 77
Both Gross Book Value and Net Book Value 4
226
Net Replacement Cost 8 Investment Centres

Both Net Book Value and Net Replacement Cost 4

Total 101
C. Establishment of ROI Targets
I
Target established in advance 84
Target not established in advance (Centres supposed
16
to do their best)
Total 100
II
Investment Centres are expected to earn a uniform
ROI percentage 14
Investment centres are assigned their own ROI
Targets based on their profit potential 86
Total 100
Source: Bhatia, M. L., Performance Measurement of Profit Centres: Practices and
Perspectives, The Chartered Accountant, Volume XXX, No.9, March 1982, pp.586-593.
Note: A survey by Govindaranja, V. and Ramamurthy B., Financial Measurement of
Investment
Centres: A Descriptive Study (cited in Anthony and Govindarajan, Management Control
Systems, 9* Ed. P. 267) found 6% and 93% of the respondents using Gross Book Value and
Net Book Value respectively, while 1% used Replacement Cost method. descriptive rather
than a normative approach in establishing ROI targets which is a healthy practice.

7.13 ECONOMIC APPRAISAL OF INVESTMENT

CENTRE
So far, the discussion was related to appraising the financial performance of
investment centres. It needs to be stressed that financial performance is one
of the yardsticks, though an important one, for measuring the managerial
performance, but it is not the only yardstick. We shall take up this subject a
little while later, that is, how the performance of investment centre managers
should be evaluated. At this point, however, we should make a distinction
between the financial performance for appraising the manager and economic
performance of the unit. Preparing the economic performance report of an
investment centre (i.e., how the investment centre has done as an economic
entity) is quite different from preparing the financial performance report
which is made quite frequently, say every quarter, or every six months.
Economic performance reports may be prepared at year end or once every
two years, three years or five years. While reports for appraising managerial
performance tend to be based on historical data (one or more years in the
past), economic reports, in addition to the historical information, may be
based more on an evaluation of future potential.

For appraising the investment centre as an economic entity, economic report

is needed which is diagnostic in nature and is meant to help evaluate current
strategies so as to arrive at a decision whether to further build, expand, divest 227
Management the division or change its direction. The economic report will reveal whether
Control Structure
the strategies and policies being pursued in regard to, products, marketing,
R&D, acquisition of plant and equipment, etc. Are satisfactory, or they need
to be changed for future satisfactory profits. Economic reports focus on
predicting future profitability, rather than analysing what profitability has
been in the past. Much of the information used in financial performance
reports like book value of assets or depreciation based on historical cost of
assets is not relevant for assessment of future for which replacement costs are
considered more useful.

Conceptually, the value of a business unit is the present value of its future
earnings stream. This is calculated by estimating cash flows for each future
year and discounting each of these annual flows at a required earnings (or
what is known as discount) rate. The analysis may cover the next 5 to 10
years. Assets on hand at the end of the period covered are assumed to have a
certain value, the terminal value, which is discounted and added to the value
of the annual cash flows.

7.14 APPRAISAL OF MANAGERIAL

PERFORMANCE
You will recall that we had discussed the performance appraisal of profit
centre managers in Unit 5. Since investment centres are an extension of the
idea of profit centres wherein the managers have an extended or additional
responsibility for effective utilization of investment in their centres, the broad
approach to performance evaluation, therefore, is similar. We have already
discussed that the financial performance of the investment centre managers is
evaluated in terms of ROI, RI or EVA, or a combination of these indices, as
decided upon by the company. However, as we maintained in unit 5 that it is
not merely the financial performance, but it is the overall job that the
investment centre manager has performed which should and needs to be
looked into and evaluated.

In view of the pitfalls and inadequacies of the popular measurement

techniques (ROI, RI , etc), some authors have suggested the alternative of
Management Audit for measuring and evaluating managerial and economic
performance in decentralized structures. Management audit is a
comprehensive, thorough and constructive examination of the various aspects
of the functioning of an organization, or any of its parts, with a view to
evaluate its overall performance. It is a critical analysis of all conceivable
areas of an organization and is usually undertaken by a team of internal and
external experts or consultants. It highlights major areas that need attention
and suggest measures to improve organizational effectiveness, both in the
short-run and the long-run.

In management literature it has been emphasized that key variables or key

success factors (KSFs) should be established for each responsibility centre
228 which would be instrumental for achieving the goals and objectives of the
responsibility centre. KSFs are those variables in the external environment to Investment Centres

which the goals, objectives, and strategy of the managers are most sensitive
(i.e., performance is highly dependent upon them). The KSFs are crucial to
the performance of organizational segments. They differ from industry to
industry, and, therefore, appropriate indicators of performance also differ for
application.

The key success factors in turn become the basis for establishing appropriate
performance measures, designating responsibility centres, reward structures
and resource allocation procedures.

To give you a feel of this approach, we give below, though somewhat dated,
the performance measures that GE (General Electric Company of USA)
developed for measuring performance of their divisions:

1. Short-term profitabi1ity
2. Market share
3. Productivity
4. Product leadership
5. Personnel development
6. Employee attitudes
7. Public responsibility
8. Balance between short-range objectives and long-range goals.

In the course of a multifaceted study on profit centres (including investment

centres), it was gathered that managerial performance is evaluated on the
basis of multiple indicators of performance rather than a single index of profit
or ROI. Though the ROI index has several benefits, as we examined in a
previous section, its imperfections and inadequacies are not unknown to the
business world. It is perhaps in recognition of this fact that companies
attempt to evaluate the performance through various other indicators which
are primarily of qualitative nature, along with ROI or some other similar
overall measure.7

Needless to say, the qualitative criteria of performance for different

companies and for different segments of the same company cannot be
similar, because of divergent conditions that may prevail (please see section
5.4 of unit 5). In view of the different goal structures, therefore, different
companies may be justified in pursuing or emphasizing different performance
indicators at the same time or different indicators for the same unit of the
company at different points of time due to changed conditions. It was
gathered that while all the respondents in the study had a system of budgetary
control and compared the actual performance of the centres against their
targeted or budgeted performance, 63 per cent also compared the actual
performance against the performance achieved in the preceding fiscal year.

229
Management The majority of the companies, it was revealed, took into account qualitative
Control Structure
indicators of performance in the evaluation process which included (in order
of preference): (i) better employee and labour relations; (ii) growth and
expansion programmes; and development of subordinates; (iii) maintenance
of quality of products and public responsibility; (iv) expanding the market
shares; (v) research and development; and (vi)conformity with broad
company policies. The consideration of qualitative indicators of performance,
in addition to terminal index like ROI, is suggestive of the concern of the
corporate managements have for cultivating a long-term perspective among
segment managers. It goes without saying that a heavy-handed emphasis on
ROI may only encourage what can be called short-termism among managers
that could have adverse consequences for the organization.8

A manager’s performance should contribute to maximisation of profits over

the long run. It is, therefore, desirable that a change or trend in the rate of
profit or return should be emphasized, rather than profit or return in one year.
A way to take care of this problem, caused by short-term results, is to
compute a moving (rolling) average from which a trend could be discerned.
Although the responding companies seemed to be concerned about long-term
profitability by considering qualitative indicators of performance, it was
somewhat disconcerting to find that nearly 40 per cent of the respondents did
not make trend analysis of quantifiable criteria (e.g., profits, ROI, production
and sales volumes, etc.) for their centres though they did this kind of exercise
for the company as a whole. It is only through the computation and analysis
of trend ratios that the true contribution of a segment towards long-term
objectives of the company can be assessed.9

Many companies in the USA have attempted linking the compensation/

rewards of profit/investment centre managers with their performance
measured in terms of financial criteria (profits, ROI, etc.). None of the
companies in the study had the compensation or rewards directly linked with
the financially measurable criteria. Nonetheless, the respondents did state that
the accomplishments on these scores (along with other indicators of
performance) were taken into consideration on a long-term basis in deciding
future salary structures, increases, promotions, and fringe benefits.10

7.15 SUMMARY
Investment centres are the highest level of responsibility centres wherein the
managers are responsible for producing profits in relation to investment in the
centres. There are some vexed problems connected with performance
measurement of investment centres that need to be tackled beforehand so that
the system can operate smoothly and efficiently.

There are two broad techniques of measuring the effectiveness of investment

centres: ROI and RI or EVA which have their merits and limitations.

ROI is a comprehensive, widely understood and generally accepted measure

230
of performance, but it suffers from some technical and implementation Investment Centres

problems. It may provide incorrect motivation on investment decisions.

RI overcomes some of the conceptual drawbacks and limitations of ROI. One

of its main merits is the flexibility it provides in applying different capital
charge rates for different types of assets depending upon their riskiness.

ROI is relatively much more popular technique is actual practice for

measuring performance of investment centres.

ROI and RI both suffer from some common pitfalls, but, conceptually, RI is a
superior measure. Measuring investment base in investment centres is beset
with difficult issues that need to be settled before applying the concept of
investment centres. And these issues are: defining investment base and
deciding the scope of invested capital; assignment of central office assets;
and valuing assets employed in the units.

The guiding force in determining what is to be included in the investment

base, ordinarily, should be the concept of controllability as applied in
Responsibility Accounting.
Invested capital is generally defined as Net Investment.
Central office assets are allocated to segments on some rational and
acceptable basis with a view to determine their real or true profitability and
return.
The assets employed in investment centres may be valued based on any one
of the three methods: Net Book Value, Gross Book Value, and Replacement
(or current) Costs. Net Book Value method is more widely used practice both
in the USA and India.
Each of the three method of valuing assets (Net Book Value, Gross Book
Value, and Replacement Costs) has its own merits and unique problems.
Which one of the methods would be desirable depends upon the situation and
thinking of corporate management. Replacement cost method is meant to
neutralize the impact of inflation and to bring the assets at the uniform
comparable level.

Annuity depreciation can resolve the problem of distortions caused by ROI

and RI, but it has not gained wide acceptance in actual practice. Economic
appraisal of investment centres is periodically undertaken to assess the
economic worth of the segments in the light of the strategic options that may
be available.

The assessment of managerial performance of investment centres should be

broad based and all relevant factors should be considered in evaluating the
performance of managers. Further, trend analysis of performance should be
undertaken regularly. Companies in India, in general, do not directly link the
compensation/rewards of investment centre managers with the financially
measurable criteria.
231
Management
Control Structure 7.16 KEYWORDS
Annuity Depreciation: Present value depreciation calculated on the basis of
annuity tables available.

Gross Book Value Method : A method for valuing fixed assets at their
original (historical) cost without deducting accumulated depreciation.

Investment Centre: A unit of the business organization whose manager is

responsible for profits in relation to invested capital or a rate of return.

Key Success Factors (KSFs):KSFs are those variables in the external

environment to which the goals, objectives, and strategy of the managers are
most sensitive. They differ from industry to industry, and, therefore,
appropriate indicators of performance also differ for application.

Management Audit: A comprehensive examination and analysis of various

aspects of an organization or its units within the light of corporate objectives
and goals.

Net Book Value Method : A method under which fixed assets are shown at
their original (historical) cost after deducting accumulated depreciation.

Replacement Cost Method : A method under which assets are shown at

their current replacement costs (usually based on current price index) in
accordance with one of the methods adopted. The concept, though sound
theoretically, has not gained wide acceptance. Residual Income (RI) : Net
income remaining after a capital charge for the use of assets in a division.

Return on Investment (ROI) : Return on investment or capital employed in

the form of a ratio or percentage.

7.17 SELF-ASSESSMENT QUESTIONS

Objective questions

1. When ROI is 15% and the cost of capital is 10%, then the project should
be rejected.(T/F)
2. When ROI is 15% and a new project yields 13%, the investment
proposal can be accepted or rejected on the basis of _______________.
3. Inflation affects ROI by bringing down the percentage of ROI over a
period of time.(T/F)
4. Replacement value of the asset is used for ROI calculations when the
division is intended to be sold.(T/F)
5. If Return on sales is low and asset turnover is high, it means that profit
can be improved by increasing the margin on sales.(T/F)
6. Cost of capital is not included in residual income. (T/F)

232
7. ROI will decrease if the incremental investment gives the same return as Investment Centres

the existing return. (T/F)

8. ROI and EVA are understated under inflationary conditions. (T/F)
9. When the cost of capital is high, leasing assets will give a lower return
on investment and hence is not preferable. (T/F)
10. Interest is always included in the calculation of ROI because the real
return on investment is after adjustment of interest. (T/F)
11. Since depreciation is only an accounting measure, the choice of method
of depreciation does not influence ROI calculations. (T/F)
12. Since input costs increase simultaneously with selling prices, the
adjustment for inflation happens automatically and therefore does not
affect ROI calculations. (T/F)
13. Capitalizing expenses with future benefits ensures that ROI is even and
relatable to the income earned. (T/F)
14. Stating assets at historical costs gives an unrealistic ROI during an
inflationary period. (T/F)
15. Since EVA is an absolute measure, it cannot even out differences in the
scale of operation. (T/F)
16. Replacement cost of assets is considered as an objective measure of the
value of assets for the calculation of ROI. (T/F)
17. Gross Book Value adjusts for the age of the asset and method of
depreciation used for ROI calculation. (T/F)
Essay Type Questions
1) Define ‘investment centre’. Why are investment centres established?
2) What are the different overall measures of effectiveness for determining
die performance of investment centres? Discuss their relative merits and
demerits.
3) Discuss the merits and drawbacks of ROI with suitable i1lustrations.
4) How and why RI (or EVA) is considered superior to ROI. Support your
answers with illustrations.
5) What difficulties may be encountered in determining the ‘investment
base’ of an investment centre? What assets might not be included in the
investment base and why?
6) Write an essay on allocation of central office assets, examining the issues
involved.
7) What are the different methods that can be used for valuing the fixed
assets in an investment centre? Critically examine their merits and
demerits
8) How do we tackle the problem created by inflation in investment centre
233
Management accounting? How can it be resolved?
Control Structure
9) What is Annuity Method of providing depreciation? Why or why not it
should be used?
10) What is meant by appraisal of investment centres as economic entities?
How is economic appraisal done?
11) “Appraisal of performance of investment centre managers should be
based on a consideration of several dimensions of performance.” What is
meant by the statement? What factors may be considered in evaluating
the performance of investment centre managers?
12)What precautions must be exercised while using ROI to measure the
performance of a Division?

Business cases

There are four divisions located in various geographic locations of Western

India Components Limited. These divisions operate out of Mumbai, Nasik,
Ahmadabad, and Goa. Each of these divisions has complete autonomy in
most of the critical business decisions. The capital requirement of these
divisions is evaluated by the top management and a project evaluation is
made before approving funds for projects. When divisions request capital
infusion at the same time, projects are ranked using various criteria including
NPV and Payback Period.

The following is a tabulation of the division-wise assets and income for 2012.

Particulars Mumbai Nasik Ahmadabad Goa

Assets
Equipment(Gross) 40 45 45 30
Equipment(Net)* 20 10 30 27
Land and 150 40 35 25
Building
Accounts 8 12 4 9
Receivable
Inventory 12 13 8 6
EBIT 38 20 16 17
Return on Assets
Rank
Incentive

*Adjusted for Depreciation

Required:
1. Rank the divisions by Return on Assets
2. Assume that the minimum desired return on assets (gross) is 15%. The
incentive is calculated as 10% of the base salary on every 1% of Return
234
 over and above the minimum return. Calculate the return for each of the Investment Centres
Divisional managers as % of his base salary.
3. Suppose the return is calculated on the net value of assets this might
result in:
a. Requesting frequent replacement of assets by the Divisions
b. Using a higher rate of depreciation or a method of depreciation that
might result in a quick write off of asset values
c. Better maintenance of equipment
d. Not replacing assets even when they are fully scrapped
4. Suppose Divisional managers are incentivized on assets purchased or
replaced in divisions-that is, in the year in which the asset is bought the
Manager gets a commission on assets purchased, this might result in
a. Frequent replacement of assets
b. Replacing assets just before quitting the Division, even if the
replacement was not entirely necessary
c. Purchasing assets that cost more
d. All of the above
5. Suppose Land and Building are eliminated from the asset base in
calculating the return and gross value of assets are used instead of net
value, it might indicate the following(you can choose more than one
answer in this case):
a. Return is calculated without reference to the place of operation
b. The higher the rate of depreciation, the better the returns look
c. There is no incentive for Divisions operating out of backward areas
or relatively underdeveloped areas
d. Divisions operating with older assets look better in terms of returns
e. The method or rate of depreciation plays no role in the calculation of
returns
f. High cost of real estate pulls down the return of the Division
6. The Randolph Teweles Company (RTC) has decided to acquire a new
truck. One alternative is to lease the truck on a 4-year guideline contract
for a lease payment of Rs.10,000 per year, with payments to be made at
the beginning of each year. The lease would include maintenance.
Alternatively, RTC could purchase the truck outright for Rs.40,000,
financing the purchase by a bank loan for the net purchase price and
amortizing the loan over 4 years at an interest rate of 10 percent per year.
Under the lease arrangement, RTC would have to maintain the truck for
$1,000 per year. The truck is depreciated at 20% per annum using the
Straight Line Method. It has a residual value of Rs.10,000, which is the
expected market value after 4 years when RTC plans to replace the truck
irrespective of whether it leases or buys. RTC has a tax rate of 40
percent.
235
Management Depreciation is allowed only on purchase and the tax shield becomes
Control Structure
available on depreciation. Interest cost is also tax-deductible and profit on the
sale of assets is taxed at the marginal tax rate of 40%

For convenience, you can assume that maintenance costs are incurred at the
beginning of the year (in the case of lease).

a. Evaluate the options to see whether it is better to buy or lease.

b. Since capital purchases depress ROI, how can businesses evaluate lease
or buy more objectively (so that the performance measure does not
discourage buying of the asset)?

7.18 REFERENCES
1) Sloan, Alfred P., 1964, My Years with General Motors. Garden City, N.
Y., Doubleday, pp. 139-140.
2) Dearden, John, The Case against ROI Control, Harvard Business
Review, May June 1969.
3) Dearden, John, Limits on Decentralized Profit Responsibility, Harvard
Business Review, July-August 1962, pp. 81-89.
4) Shilling law, Gordon, 1971, Cost Accounting: Analysis and Control,
Taraporewala. Mumbai , p.790.
5) Bhatia, M. L., Performance Measurement of Profit Centres'. Practices
and Perspectives, The Chartered Accountant, Volume XXX, No. 9. p.
587
6) Anthony, R. N., and Givindarajan, V., Management Control Systems (9*
ed.), Tata McGraw-Hill, 1999, p. 276. Bhatia , M. L., Performance
Evaluation in Decentralized Structures: Empirical Perspectives, The
Management Accountant, January 1983, pp. 9-11.

7.17 FURTHER READINGS

Anthony and Govindarajan, Management Control Systems, 12th Edition, Tata
McGraw Hill
A.J. Pienaar, S. Buchner & J. FootHand Book (F-6) on EVA published by
United States Postal Service.
Anonym. (2019). Management Control Systems: Different Types of Control
Management. On the Effectiveness, the Advantages and the
Disadvantages. Germany: GRIN Verlag.
Bhatia, M. L., Performance Measurement of Profit Centres: Practices and
Perspectives, The Chartered Accountant, Volume XXX, No.9, March 1982,
pp.583- 596.
Hoozée, S., Bruggeman, W., Slagmulder, R. (2018). Management Control:
Concepts, Methods and Practices. United Kingdom: Intersentia.

236
 Investment Centres

Marciariello, Joseph A. and Kirby, Calvin J., Management Control Systems,

Prentice Hall of India (Latest Edition) (Chapter 3 & 6).
Nilsson, G., Anthony, R., Hartmann, F., Kraus, K., Govindarajan, V. (2020).
EBOOK: Management Control Systems, 2e. Spain: McGraw-Hill Education.
Robert Kaplan, Anthony Atkinson, Advanced management Accounting 3rd
Edition, Pearson
Vancil, Richard, F., 1979, Decentralization: Management Ambiguity by
Design, Dow- 110 Jones-Irwin.
“An overview of the implementation of Economic Value Added (EVA™)
performance measures in South Africa “by H.M. van der Poll, N.J. Booyse,

237
Management
Control Structure UNIT 8 TRANSFER PRICING

Objectives

After studying this Unit, you should be able to:

• understand the concept of transfer pricing;
• understand the various methods and criteria of transfer pricing;
• know about various categories of Inter-company transfer;
• distinguish between various intangibles and learn how intangibles are
transfered;
• understand the concept of arm’s length principle; and
• calculate the arm’s length transfer price.

Structure
8.1 Introduction
8.2 Methods and Criteria of Transfer Pricing
8.3 Categories of Inter-company Transfer
8.4 Types of Intangibles
8.5 Modes of Transfer of Intangibles
8.6 Other Categories of Inter-company Transfer
8.7 The Arm’s Length Principle
8.8 Application of the Arm’s Length Principle

8.1 INTRODUCTION
An expressed characteristic of the market economy today is the establishing
and functioning of complex and large enterprises with diverse production
lines, hierarchy of rights and responsibilities of employees, market dispersion
and decentralized organizational structure and management. Establishing
organizational units includes fragmentation of resources of enterprises and
transferring competences and responsibilities for their allocation on cost,
profit and investment centers. Although profit and investment centers are
relatively independent units with their own goals, the recognized external
market of goods and production factors, and their own profit responsibility,
they are not totally independent from the other profit oriented organizational
parts of the enterprise. Namely, many business transactions could be
performed between the units (centers). Those so-called internal exchanges of
products/ services are the basis of the internal transfer - output of one profit
center may be sold to the other profit units inside of the enterprise. This is the
way to develop an internal market inside the decentralized enterprise, its
products/services become intermediate, and valuable expression of the
internal transfer seems to be internal - transfer prices. Transfer pricing has
238 become one of the important elements of efficient management of a
decentralized enterprise. What is Transfer Pricing? Multinational enterprises Transfer Pricing

(MNEs) carry on business in more than one country either directly, through
branches, or indirectly through subsidiaries. Whatever the form, the activities
of an MNE’s individual operating units are rarely completely self-sustaining
or independent with the result that transactions take place between these
units. The price at which goods, services or capital are exchanged between
the related parties is known as transfer price. The transfer price is determined
by the transfer-pricing policies used within the related group. The transfer
price received or charged for goods, services or financing will be included in
the income of supplier and the corresponding cost or payments will be
deducted from the profits of the legal entity benefiting from the transaction
and making the payments. Often the amount of these charges represents one
of the largest inclusions or deductions in computing the income of one or
both of the related parties. From a business perspective, there are many
dimensions to deciding what to charge for the inter company exchange of
goods or services. Compensation and performance measurement may push in
one direction; and tax considerations may push in another. Other factors may
come into play as well. Governments, through their tax systems, have a
vested interest in ensuring that appropriate profits are reported in their
jurisdiction. Government concerns are heightened when one of the parties to
a related-party transaction is subject to tax at a rate that is considerably less
than that applying in the other related party’s country. In addition to tax-rate
pressures, other government pressures can be brought to bear on the transfer
pricing decision, including heavy penalties or restrictive measures dealing
with related-party transactions. Transfer Pricing Manipulation This leads us
to the point of Transfer Pricing Manipulation (TPM). It is TPM that is
discouraged by Governments as against Transfer Pricing which is the act of
pricing. TPM is fixing transfer price on non-market basis which generally
results in saving the total quantum of organization’s tax by shifting
accounting profits from high tax to low tax jurisdictions. The implication is
moving of one nation’s tax revenue to another. A similar phenomenon exists
in domestic markets where different states attract investment by under cutting
Sales tax rates, leading to outflow from one state to another, something the
Government is trying to curb by way of implementation of VAT.

Motivations for TPM:

It is not just the Corporate Tax differential that induces organizations to
manipulations in Transfer Pricing. Some of the other reasons are:
• High Customs Duty-leading to under-invoicing of goods.
• Restriction on Profit Repatriation-leading to over-invoicing of raw
materials, etc. transferred from parent country, hence compensating for
locked forex.
• Ownership Restrictions (e.g. Insurance Sector-26%)-since this leads to
less than justified returns on the technology or knowledge invested in the
JV, MNEs circumvent it through over charging on royalties for
technology, etc. 239
Management There can be various other similar motivations for TPM. The transactions
Control Structure
most likely disputed by Governments are Administration & Management
Fees, Royalties for intangibles and transfer of finished goods for resale.

Effects of TPM on Nations

One primary effect is the loss of Government Tax and Custom Duty
revenues. Loss of tax revenues in this form leads to a burden on the rest of
the population through over taxation and/or borrowings by the Government,
which becomes essential to meet expenditure requirements. TPM also leads
to distortions in Balance of Payments between the host and home country,
something that has the potential to challenge the sovereignty of nations given
another implication is on the location of international production and
employment. Given the objective of maximization of global profits, MNEs
will open subsidiaries where production is most profitable, which is where
tax burden is less and therefore affect the level of FDI a country gets. This
linkage is so strong that some countries like Hongkong and Singapore have
no Transfer Pricing controls, making themselves attractive destinations for
FDI. Undesirable Corporate Practices Related to Transfer Pricing Some of
the related party transactions, which are usually resorted to for diversion of
funds are detailed below.

a) Purchase of goods or services from a related party at little or no cost or at

inflated prices to the entity.
b) Payments for services never rendered or at inflated prices.
c) Sales at below market rates to an unnecessary “middle man” related
party, who in turn sells to the ultimate customer at a higher price with the
related party (and ultimately its principals) retaining the difference.
d) Purchases of assets at prices in excess of fair market value.
e) Use of trade names or patent rights at exorbitant rates even after their
expiry or at a price much higher than the price, which cannot be
described as reasonable.
f) Borrowing or lending on an interest-free basis or at a rate of interest
significantly above or below market rates prevailing at the time of the
transaction.
g) Exchanging property for similar property in a non monetary transaction.
h) Selling real estate at a price that differs significantly from its appraised
value.
i) Accruing interest at above market rates on loans.

Activity 1

i) Note down the conditions which make transfer prices necessary.

……………………………………………………………………………

240 ……………………………………………………………………………
ii) List some of the possible situations in which Transfer Pricing Transfer Pricing

Manipulations can be resorted to.

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

8.2 METHODS AND CRITERIA OF TRANSFER

PRICING
Many enterprises today have a decentralized structure with some variation of
vertical integration in which the result of one unit (center) becomes the input
of another unit. Transfer price is the financial basis used to quantify the
transfer of products and services from one unit to another. It enables to
determine if the participation of each participant (unit) in the internal transfer
is adequate and correct, as well as to measure its efficiency. Transfer pricing
has become a very influential factor of efficient management and one of the
most important elements in performance measurement of decentralized
enterprise and its parts. The internal transfer of products or services can
impact positively or negatively the performance measures used for
organizational units (centers) just the same as the external transfer of
products and services. It should be obvious that a conflict is likely to arise in
an enterprise between its center managers because the “buyer” center wants
the transfer price to be as low as possible while the “seller” center wants the
transfer price to be as high as possible. Therefore, when an exchange of
products or services takes place between a center and an external party, the
forces of demand and supply on market determine the price in external
transactions. An exchange of products or services between a center and an
internal party, however, poses a potentially more serious and complex
problem than the external exchange. What transfer price should be set so that
buying and selling centers, acting in their own best interests, will at the same
time act in the best interests of the enterprise as a whole? This is a serious
question because sub optimal decision making will result if either.

1. the buying center manager goes to an external supplier to satisfy his

needs when he should have gone to the selling center manager or

2. the buying center manager goes to the selling center manager to satisfy
his needs when he should have gone to an external supplier.

Consequently, upper-level management may insist that the buying and selling
centers, although they are theoretically autonomous units, always take only
those actions that are in the best interests of the enterprise as a whole, which
may result in undesirable behavior of centers and their managers and pseudo 241
Management centralization. The solution of the problem of inadequate decision-making on
Control Structure
different managerial levels in the enterprise could be a reliable information
basis for transfer prices, as they should be the significant informational input
for managers on all levels and express real performance of each center. There
are several different methods for determining transfer prices. The basic
methods are cost-based transfer pricing, cost-plus transfer pricing (full costs
plus normal markup), negotiated transfer pricing (results of negotiations
between buying and selling centers) and market-based transfer pricing (if
there is an external market price for intermediate products or services). Also,
there are certain alternative methods, such as synthetic market pricing
(incorporating opportunity cost to the enterprise as a whole), and dual
transfer pricing system. The transfer pricing method used must be the one
most beneficial to the enterprise. The following four interrelated criteria
should be used to evaluate adequacy of the transfer pricing methods that are
currently being used by profit or investment centers.
1. Goal congruence: The transfer prices that are set should enable a
harmonization of goals of enterprise as a whole and its parties (centers)
as well to avoid sub optimal decision-making.
2. Motivation: Transfer prices should not interfere with the process
wherein the buying center manager rationally strives to minimize his
costs and the selling center manager rationally strives to maximize his
revenues.
3. Autonomy: Each center manager should be free to satisfy his own needs
either internally or externally at the best possible price. This also means a
higher autonomy of profit or investment centers in the enterprise.
4. Performance evaluation: Transfer prices should enable objective
evaluation of profit center results giving the information for optimal
decision-making and real appraisal of managerial performance and
economic value of particular parties of the enterprise.
In accordance with the criteria, the transfer pricing method should be chosen
in the way to be the most beneficial for the enterprise as a whole as well as
for its organizational parties. Frequently, the choice of the method is
connected with the motivation and autonomy of profit (or investment) center
managers and their maximum coordination. Each of the various transfer
pricing methods currently in use will be discussed only in relation to profit
centers for two reasons: First, transfer prices impact on profit and investment
centers in an identical manner; and second, the analysis will be more efficient
and comprehensive by being restricted to a single type of responsibility
center.

8.3 CATEGORIES OFINTER COMPANY

TRANSFER
There are various forms of intra-company transaction. These transactions can
242 be in the form of:
• transfers of tangible property and intangible property and Transfer Pricing

• the provision of services and finance

• rentals and leasing arrangements.

To determine whether an intra company transfer has occurred or not the

substance and situation of the transaction will determine whether or not a
transaction has taken place, rather than whether an invoice is rendered.
Universally, the basis for determining consideration for intra company
transactions is the arm’s length principle.

Sales of Tangible Property – Definition Tangible properties are the physical

assets of a business. Tangible assets can be further classified as

• Current tangible assets and

• Fixed tangible assets

It is the current tangible assets in the form of raw material, work in progress,
sub assemblies and finished goods that constitute a major portion of the
transfers in the form of sales that take place between related parties.

Sales of tangible property also include all the machinery and equipment
employed by businesses. Transfer pricing rules generally stipulate that arm’s
length prices be used for determining sales consideration for sale of tangible
assets between affiliates or related parties. The most often used technique to
determine Arm’s length price is to compare the prices of ‘comparable’
products and services. Comparable products are very similar, if not identical,
products, which are sold between unrelated parties under substantially similar
economic circumstances, i.e. when the market conditions affecting the
transactions are similar and when the functions performed, risks borne and
intangible assets developed by the respective unrelated trading parties
coincide with those of the related parties. Sales of Machinery and Equipment
Machinery and equipment is frequently provided to manufacturing affiliates
by the parent company. For example, this may be a means of providing
support to an existing subsidiary or it may be in the form of the sale of
complete manufacturing lines to a new company in a ‘greenfield’ situation.
The equipment may have been purchased from an unrelated company,
manufactured by the parent or might be older equipment that the parent (or
another manufacturing affiliate) no longer needs. Tax rules generally require
that the transferor of this equipment (whether new or used, manufactured or
purchased) should receive an arm’s length consideration for the equipment.
This is generally considered to be the fair market value of the equipment at
the time of transfer.

Example ABC Inc. (ABCI), is a US company, manufactures and sells in Asia

through an Indian subsidiary, XYZ Ltd. (XYZL). XYZL manufactures one
product, where one major sub assembly (1st Sub Assembly) of the product is
produced by ABCI. Transistors which are other major sub components are
centrally purchased by ABCI through a worldwide contract for all of its 243
Management subsidiaries worldwide. Packaging material IS purchased by XYZL locally
Control Structure
from a third party. Apart from this a proprietary testing machine, developed
ABCI, is supplied by ABCI. In this particular case, there are three intra-
company sales of tangible property by ABCI to XYZL:

• sale of the testing machine;

• the sale of 1st Sub assembly; and
• the sale of transistors purchased from unrelated parties. In each case, the
amount reflected in invoices must be based on an arm’s length price
Transfers of Intangible Property – Definition Paragraph 6.2 of the OECD
guidelines provides a general description of intangible property:

8.4 TYPES OF INTANGIBLES

The term “ intangible property includes rights to use industrial assets such as
patents, trademarks, trade names, designs or models. It also includes literary
and artistic property rights, and intellectual property such as know-how and
trade secrets. ...

These intangibles are assets that may have considerable value even though
they may have no book value in the company’s balance sheet.

There also may be considerable risks associated with them (e.g., contract or
product liability and environmental damages).”

Barriers to entry are also considered as Intangible assets as they create a

situation where the profits of a company over a long period of time exceed
the levels that would generally accrue to a normal firm operating in similar
economic conditions. Barriers to entry generally arise when the firm has
some sort of monopoly control either in the form of technology, exclusive
rights over natural resources, financial muscle power with excess to low cost
of financing etc. Barriers to entry have the potential to create an absolute
monopoly for the owner or creator of the barrier. For example, in Aluminum
production Bauxite is a major raw material and in USA Aluminum Company
of America (ALCOA) owned the world’s source of bauxite which resulted in
creation of major barrier to entry for other aluminum producers. This
situation was remedied when the US courts forced ALCOA to divest itself of
some of the bauxite reserves. Some barriers to entry can be created by
investing in research and development which results into grant of exclusive
Patents if the R&D efforts are successful. For example, the pharmaceutical
company Eli Lilly owned the patent on a drug sold as ‘DarvonL this patent
was so effective that no competitor was able to develop a drug that could
compete with Darvonl until the patent expired. For the purpose of transfer
pricing Examples of intangible assets include goodwill, patents, trademarks,
the ability to provide services, and many others. Intangibles which act as
barriers to entry and also produce a monopoly or near-monopoly in their
product and service areas are sometimes referred to as ‘super-intangibles’.
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As per the OECD guidelines intangible property is classified in two broad Transfer Pricing

types: a) Manufacturing Intangibles b) Marketing Intangibles. Manufacturing

intangibles are result of research and development (R&D) efforts undertaken
during product development. The experiences and learning at R&D efforts
stage is used in the manufacturing process creating a competitive edge for the
manufacture and this manufacturing edge is difficult to copy until and unless
the same is transferred through license or royalty agreement. On the other
hand Marketing intangibles are created by the company through unique
positioning of the product, brand development and sustained advertising and
communication creating a unique perception about the product and services.
In addition sales and distribution network along with after-sales service
efforts also contributes in development and creation of marketing intangibles.

The basic reason for distinguishing between these two types of intangibles is
that both of these contribute in the creation of value for product and services
but the contribution may vary depending on the circumstances of the
transaction. Since they have distinct features and associated value
understanding the distinction will help in correct application of the arm’s
length principle.

Manufacturing Intangibles Patents and non-patented technical know-how

which is exclusive to a company are the primary types of manufacturing
intangibles. “A patent is governments grant of a right that guarantees the
inventor that his/her invention will be protected from use by others for a
period of time”. This period varies from one country to another and, to a
lesser extent, according to the product. Just grant of patent can’t safeguard
the right of the patent holders as Patents can be either very effective barriers
to entry or quite ineffective barriers. For example many drug companies
circumvent patents of other companies by reverse engineering of a particular
medicinal compound or by combining two compounds. Very effective
barriers create an absolute monopoly for the owner for the life of the patent.
Ineffective barriers are created by patents that can easily be ‘designed
around’ or cover only minor aspects of a product. For transfer pricing
purpose this distinction between effective and non effective patents is of
considerable importance as the consideration for transfer/right to use patents
will depend on the effectiveness of the patents. The degree of monopoly
power carried by the patent will determine compensation due to the
transferor. Technical know-how is the accumulated specific knowledge
through which a manufacturer produces a product. For general routine
manufacturing technical know-how is worth very little as it is known to all or
is easily accessible, so that when it is transferred between unrelated parties
the royalty rate is extremely low. In other industries, technical know-how is
highly valuable and this type of technical knowhow results in unique
products, cost and time reduction in manufacturing and substantial savings in
the manufacturing process. For transfer pricing purpose there should be a
distinction in pricing when low level and high level technical knowhow is
transferred between affiliates. Marketing Intangibles Have you ever
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Management wondered that the products like soaps, shampoo, hair oil, shaving cream,
Control Structure
facial creams etc manufactured by the biggest FMCG companies does not
require any specific or unique technology or technology which is not
accessible to others, yet inspite of lack of any apparent entry barrier very few
other manufacturers have ventured into production and marketing of these
products. The probable reason for this is the marketing intangibles which
these companies have created for themselves, which makes it extremely
difficult for other companies to penetrate this market. Marketing intangibles
create entry barriers through a complex interplay of trademarks, trade names,
corporate reputation. In addition the existence of a developed sales force and
the ability to provide after sales services and training to customers also deters
others to venture into those products which have strong marketing intangibles
associated with them.

A trademark is a distinctive identification of a manufactured product in the

form of a name, logo, etc. A trade name is the name under which an
organisation conducts its business. Trademark is a product-specific
intangible, while the trade name is a company-specific intangible.

A product-specific intangible applies to a particular product and its value is

created over a period of time by the intrinsic features of the product and by
the marketing and sales techniques. A new product introduced by the
affiliate/subsidiary in a new market will have zero value at the time the
product is marketed for the first time under that name. From the transfer
pricing perspective this is important as the affiliate must be paying something
for the rights to market a product in a particular territory, but at the same time
it may have high value in the markets into which the product is already being
sold.

A company-specific intangible is one that applies to all products marketed by

a company irrespective of the category of the product. For transfer pricing
purpose the power associated with Product intangibles has to be distinguished
from the power associated with company specific intangibles the brand name
evolves from interaction of product intangibles and company specific
intangibles. This type of intangible includes new, as well as existing,
products and has value in most markets at the time the products are
introduced into these markets. Corporate reputation represents the
accumulated goodwill of a corporation and evolves through complex
interaction of products, services, after sales services, advertising and
promotion and general corporate behaviour and is sometimes used as a
synonym for trade name. Strong corporate reputation often leads to higher
share of market share. Service to customers after a sale, and training of
customers in the use of a product, are extremely important in some industries
in some industries like scientific instruments, medical diagnostic instruments,
heavy machinery etc. In fact, in some industries, this intangible is the one that
keeps the company in business.

246 Hybrid Intangibles

 Intangibles associated with product, brand and company evolve over a Transfer Pricing

period of time and it is not possible to attribute particular factors (marketing

or manufacturing) that contribute to creation of tangibles. In view of this
prolonged and complex interaction it is not possible to classify every
intangible as either as a manufacturing or a marketing intangible. Some
intangibles can be both. For example, corporate reputation may result from
the fact that a company has historically produced high quality goods and
provided superior after sales services the reputation that results from this is
clearly a manufacturing intangible plus after sales service intangible. In
another example, suppose that corporate reputation of a particular company
evolves due to its marketing and advertising efforts along with unique
product offering like Coca Cola or Dettol, In this case, corporate reputation is
a very powerful marketing intangible. .

8.5 MODES OFTRANSFER OF INTANGIBLES

There are four broad ways through which Intangibles can be transferred
between related entities, which are as follows:

1. Outright sale for consideration;

2. Outright transfer for no remuneration, i.e. by way of gift;
3. License in exchange for a royalty (lump sum or periodic payment based
on a percentage of sales, sum per unit, etc.); or
4. royalty-free license.

As a general rule, method no. 2&4 transfers without remuneration are not
accepted by the tax authorities of any country except for in the limited
context of property owned and exploited from tax havens or business
reorganizations that attract special tax reliefs. Method no 1&3 are commonly
used and are the primary method of transfer of intangibles. apply The arm’s
length principle is difficult to apply in case of transfer of intangibles between
related parties for tax purpose due to the following reasons:

• When both tangible and intangible features are bundled together to form
a single product it would be difficult to ascertain the precise nature of the
transaction as the transaction involves a number of sub components
representing both, tangible and intangible features
• The transaction may be for a product or service having a special
character thereby complicating the search for comparables as very few or
none of the comparable transactions may occur or exist.
• Related parties for entirely commercial reasons within the ambit of
prevailing commercial and tax laws may structure their transactions in
ways that would generally not be structured and transacted by
independent firms or unrelated firms. In this kind of situation sound
functional analysis can assist in application of the arm’s length principle
to intangible property.
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Management
Control Structure
Functional analysis can help identify:
• the circumstances leading to the development and creation of intangible
value, the entity that had financed the development and creation of
intangible and as a result to this ,which entity the rewards will accrue to
in case those intangibles are used by some other entity
• Who is the real “owner” of the intangible is
• What is the true nature of the transaction and features of the property
being transferred in the transaction
• The terms and conditions under which a related party is using an
intangible (for example, whether the user is a licensee of the intangible,
or merely a contract distributor). Sales of both intangibles and tangible
property, are treated in the same way , the transactions regarding these
shall be based on arm’s length standard and should reflect the fair market
value of the property at the time of sale.

Activity 2

a) List the various types of intangibles of your company.

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

b) List some of Manufacturing and Marketing intangibles of various

companies.

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

8.6 OTHER CATEGORIES OF INTER

COMPANY TRANSFER
The Provision of Services – In order to save cost and have control over the
affairs of the company some services may be offered by affiliates to all the
group companies including the parent company or vice versa services may be
offered by parent company to affiliates. These services can range from
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relatively simple recurring services ace such as accounting, legal or tax to Transfer Pricing

complex technical assistance associated with transfers of intangibles. The

pricing of service fees is a complex and difficult intercompany pricing issue.
The general principle governing the transfer pricing of these services is that
arm’s length charges are made for any service rendered to an overseas
affiliate. Arm’s length’ is defined as the cost of providing the service, plus an
allowance of a small margin of profit. In case excess amount is charged than
only arm’s length charges for services that are directly beneficial to the
affiliate can be deducted by an affiliate in its tax return. Examples of Types
of Service Services which are provided to affiliates are generally categorized
into four categories as follows:

1. Routine Services: In the first category routine services like accounting,

legal or back office services are offered to affiliates. In these kind of
services there is no transfer of intangibles and price of services shall be
based on arms length principle which basically based on cost plus
formula , where the ‘plus’ element is determined by the quantum of the
value-added and the extent of competition within the service providing
market. For the transfer pricing purpose, many countries allow
reimbursement on a cost plus basis and this cost plus are typically of
around five to ten per cent. However, a few countries disallow the
inclusion of a profit or have restrictive rules.

2. Technical Services (Intangible Services): When technical services are

provided by parent company to affiliates under a license agreement
either for manufacturing or marketing intangible and are based on an
arm’s length relationships a certain quantum of technical assistance is
provided in connection with a license agreement (at no extra charge). If
affiliates are new in business and require services in excess of this level
are needed, arm’s length agreements usually allow for this at an extra
charge, typically a per diem amount (itself determined on a cost plus
basis) plus out-of-pocket expenses.

3. Technical Services (Tangible Services): When the parent company

provides services which are technical in nature (pertaining to
manufacturing, quality control or technical marketing) and are not
related to manufacturing and marketing intangibles the services provided
are paid for on an arm’s length basis.

4. Most of the time affiliates are situated in developing countries and they
often lack experienced managers and technocrats. To remedy this
situation the parent company may depute some key personnel’s to
affiliates to oversee the execution of the project and stabilize the business
operations in initial years. Such an arrangement usually exists for initial
three to five years of the initiation of the project. Some tax jurisdictions
treat this type of arrangements as transfer of intangibles and tax the
income of parent company accordingly. In all the above situations the
substance of the relationship is that the parent company is managing the 249
Management affairs of the affiliates with minimal inputs from the affiliate itself .In
Control Structure
these circumstances the parent company tax authorities would be
inclined to infer that profit allowed to affiliate should be minimal as here
the affiliate is performing the service for the parent company through a
contract manufacturer arrangement, a manufacturer’s representative
arrangement, The effect of such an inference would be that the amount of
tax liability would shift to the parent company. Financing Transactions
The parent companies are generally well established and have a long
corporate history leading to higher credit rating for their financial
instruments based on which it can easily accesses finance from banks,
debt markets, public issues and other sources. Apart from this the amount
of retained earnings(internal finance) is also of high magnitude with
them. In addition the parent companies which are based in USA, Europe
and Japan have access to low cost of fund due to lower rate of interest
prevailing in these countries. Combination of all these factors result in
the parent financing the operations of affiliates in the initial stages and
even in later stages and the affiliates choosing to raise finance from
parents rather than local sources. For financing arrangements between
the parent and affiliates and for other related party transactions the arm’s
length principle generally applies. In order to apply the arm’s length
terms are in place it is necessary to analyse all the various forms of
finance that are being provided by one related party (often the parent
company) to another. Following factors are of relevance in the context of
debt advanced by parent to affiliate. • The rate of interest on the loan; •
the amount of the loan; • the currency of the loan and repayment
currency for interest and principal amount • the credit worthiness of this
borrower (including whether or not any guarantees have been provided
in connection with the loan). In these type of financing agreements tax
authorities would review the following points: Whether a third party
independent entity would charge the same rate of interest as set between
the related parties and if not whether that rate is too high or low. The tax
authority in the borrower’s country may also review whether a third
party would have been willing to lend the funds at all based on the credit
standing of the borrower. If the tax authorities on examination conclude
that the rate of interest charged is not as per the arm’s length principle
viz. the interest charged is either low or high the following consequences
may arise for the parent and affiliate. If tax authorities conclude that the
interest rate is too low, the tax authorities of the lender’s country may
deem additional interest income to arise and tax this notional income
accordingly. This deemed additional income would be the difference in
the interest if the interest was charged at arm’s length principle instead of
what is being charged. If the tax authority in the recipient country
concludes that interest charged is too high or the absolute quantum of
interest being paid by the borrower is too much (because the rate is too
high and/or because the amount of the debt is too great) the tax
authorities in the recipient country may :
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• disallow major portion of interest paid or accrued for tax deduction Transfer Pricing

purpose due to which the tax liability of the recipient will increase

• Interest paid may be recharacterised as dividends, which may result in

additional withholding taxes being due. If it is considered that an entity
has related party debt in excess of the amount that a third party would
lend, the borrower is said to be ‘thinly capitalized’. Many countries,
particularly the developed nations, have special thin capitalization rules
or practices. Discuss thin Capitalization Financing Short-term Capital
Needs An affiliate apart from requiring long term debt may also require
short term finance. These short term requirement is primarily for
working capital finance. Apart from this an affiliate may require short
term finance when it is initially set up or when it is introducing a new
product line or going for rapid expansion. A parent company finances its
affiliates through the following means:

• Intra-company payables and receivables;

• Advances of capital from a related party;
• Related party guaranteed loans; or

• Market penetration payments. Market Penetration Payments When the

parent company decides to set up an affiliate in some other country, the
affiliate and its products are little known in the host country. To establish
and increase market share the parent company may resort to market
penetration or market maintenance mechanism. Since the product and
services of the parent company are little known in the host country and
lacking recall and brand value in the host country the parent company for
a temporary period may treat the market of the affiliate as its own and
deploy funds to capture the market share. These funds are basically used
for marketing through advertising or under pricing of products and
services, under pricing in the context means pricing the product below
the price that is expected to be charged after achieving the desired level
of sales. Now the question which arises is how to treat these expenses
.Whether these expenses are the expenses of the parent company or the
expenses of the affiliate .These costs are the costs of the parent rather
than that of the affiliate. Market penetration activity can be funded in two
ways either through a lump-sum payment to cover the market penetration
costs or, alternatively, by reduction in transfer prices for the market
penetration period. While pursuing any of the two methods it is
important to note that documentation should be done properly to defend
again any tax liability as both of these approaches will lead to decrease
of tax liability for the parent company. Reduction of transfer prices can’t
be permanent in nature because the profits of the subsidiary would
eventually become excessive and cause transfer pricing problems in the
future. These kinds of agreements usually last for a period of 3 to 5
years. When the affiliate is well established is running for a fairly long
period of time but is faced by increased competition may resort to
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Management reducing prices to customers or y significantly increasing marketing
Control Structure
activity to ward of competition and to maintain its market share. These
costs are known as market maintenance cost, The cost of this activity are
funded in the same way as market penetration, that is, either through a
lump-sum payment or through a reduction of the transfer price. Cost-
sharing The affiliates of the parent company are spread all over the world
and some of the affiliate may have some competitive advantage over
others in the form of access to skilled manpower, low cost of operations
and higher degree of technical knowhow ,but in spite of having these
advantages it may not be in a financial position to carry out activities like
R&D because its local sales are quite minimal as compared to other
affiliates or parents. The parent company may be also hesitant to invest
funds in R&D efforts as there is likely hood of domestic profits falling
.The way out is Cost-sharing, by which companies finance a major R&D
effort. In this agreement parent company/profitable affiliates enter into a
cost-sharing agreement with other affiliates to finance the R&D activity
of the group. Financing Long-term Capital Needs Long-term capital
needs can be financed through: • mortgages; • lease financing; • capital
stock; • long-term debt (either inter-company or third party); or •the issue
of equity to shareholders, and bonds or other financial instruments in the
marketplace Mortgages the land can be purchased through outright
payment or through a mortgage. When the affiliate is short of funds, use
of a mortgage will spread the total cash outlay over a period of years.
Most of the times, the interest rate on mortgages is lower than for
unsecured loans (whether short or long-term),therefore it would be
cheaper for both the parent and the affiliate to fund acquisition of land
through this route rather than depending on debt financing from the
parent. In addition interest on mortgages is a tax deductible expense
which would bring the absolute tax liability of the affiliate to a lower
level. In case the mortgage is obtained from a related party than an arm’s
length principle should be followed with regard to the interest rate and
terms and they should be the same as would have been obtained from an
unrelated party. Lease Financing Capital equipments are costly and
require huge funds which may not be available with the affiliates. So the
way out for the affiliate is to lease capital equipment from a related or
unrelated party. The financial effect of leasing is same as mortgage
where instead of making a lump-sum payment for the asset the payments
are spread over a number of years. In case the lease is obtained from a
related party, the terms must be the same as would have resulted had the
lease been obtained from an unrelated party. Capital Stock The parent
can provide capital to a subsidiary through purchase of capital stock in
the subsidiary. This is probably the most straightforward method of
financing the long term needs of a subsidiary but is relatively difficult to
adjust quickly to meet changing needs. From a planning perspective, it
can sometimes be preferable to issue shares at a premium rather than
issue more shares at the same nominal value. This is because many
252
 jurisdictions allow the repayment of share premium while a reduction of Transfer Pricing

share capital often requires relatively complex and formal legal

proceedings, or may not be possible at all. The flexibility gained will
probably weaken the balance sheet somewhat where such arrangements
exist. Long-term Inter-company Loans A parent company will usually
have the flexibility to lend funds to subsidiaries directly in the form of
loans, whether secured or unsecured. Most parent company jurisdictions
require that the parent charge an arm’s length rate of interest on the loan
based on the term of the loan, the currency involved and the credit risk
associated with the subsidiary. At the subsidiary level, tax deductions are
normally available for interest expense. However, thin capitalization is
increasingly an area that is scrutinized by tax authorities, so particular
attention must be given to the gearing levels acceptable in the borrowing
country. Careful attention must also be given to any double taxation
agreement in force between the countries involved. . .

8.7 THEARM’S LENGTH PRINCIPLE

The basic premise of the arm’s length principle is that the compensation/
consideration for any intercompany transaction shall conform to the level that
would have applied had the transaction taken place between unrelated parties,
all other factors remaining the same. Factors that weighs in the determination
of arm’s length price are: • the type of transaction under review, •the
economic and commercial factors underlying the transaction. • The form of
the payment viz. either lump sum payment or a stream of royalty payments
spread over predetermined period

The arm’s length principle requires that, for tax purposes, the terms and
conditions agreed to between non-arm’s length parties (related parties) for
commercial or financial transactions between themselves be similar or
identical to those that arm’s length parties (independent parties) would have
followed in their commercial and financial transactions while dealing with
each other .

The prerequisite for application of the arm’s length principle is that the for
the purpose of comparison of price or margin in transactions involving non-
arm’s length parties with those of the price/margin in transactions involving
arm’s length parties, the transactions must be similar in nature. For the
comparison to be valid and reliable commercially and economically relevant
characteristics of the transaction being compared must be at least sufficiently
similar so as to permit reasonably accurate adjustments to be made for any
differences in such characteristics .

Comparison of transactions shall always between the transactions of related

party with that of unrelated parties. Transactions between other non-arm’s
length parties should not be used for purposes of these comparisons, because
the terms and conditions may not be arm’s length.
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Management
Control Structure
Paragraphs 1.19 through 1.35 of the OECD Guidelines indicate that must be
taken into consideration to compare the transactions among unrelated parties
some of these factors are:

• the characteristics of the gods and services being transacted;

• apart from the basic transactions the additional functions performed by
the parties to the transactions and the resources committed and risk
assumed by each party
• the commercial terms and conditions of the contract; • the financial
health of the parties; and
• the commercial, financial & business strategies pursued by the parties.

The related parties entering into transaction and looking for comparable
transactions must analyse the comparable transactions in light of the above
mentioned five points and exercise judgement in determining the level to
which the transactions can be compared. The degree of comparison will also
be influenced by availability of quality information regarding the factors
present in the uncontrolled transaction (transaction between unrelated
parties).

Business strategies are often varied and devised as per the specific
requirements of the business concern and any variation in the strategy can
affect comparability . For example, where an arm’s length party (unrelated
business concern) is planning to introduce a product into a new market or
increase its market share, one of the strategy can be to be a price leader in the
market where in it may for a short period of time price its product and
services at a price which would be lower than what would be priced normal
course of business. This trade off of price is the cost of the potential i long-
term benefits of such a strategy. However this kind of strategy will not
continue lor the long term ,they are designed for a short term or until the
desired level of sales is achieved. Some transactions may be interlinked or are
continuous in nature making them difficult to be analysed and evaluated on
standalone basis. In such circumstances the alternative is to bundle all the
transactions together and analyse accordingly. Few of the examples of such
transactions are: • some long-term contracts for the supply of commodities or
services for example a coal mining subsidiary of a thermal plant (parent
company) supplying coal under long term contract; • entitlement to use
intangible property like brand name, logo etc., for long term • price of closely
linked products with minor differences and it is not feasible to determine
price for individual product or transaction

While deciding on whether to price a series of transactions on aggregate basis

or on standalone basis the following factors shall be taken into consideration.
• The level of intangibles associated with the series of transactions and the
value imbedded in the intangible component of the transaction; • availability
254
of quality information on comparable transactions to make suitable Transfer Pricing

adjustments to arrive at fair market value of the transaction; • functional

comparability of transactions; and • additional costs associated with valuing
transactions separately.

Irrespective of the fact that a set of transactions is priced collectively or on

standalone basis individually will not alter the underlying nature of the
transaction.

Terms of transactions between related parties may be different from those

terms of transaction between unrelated parties but it does not imply that the
transactions are not based on arms length principle rather than this they
reflect the fact that related parties operate under different commercial
circumstances as compared to unrelated parties. Tax authorities in general
would not dispute the structure of a transaction and they would accept
business transactions as they are structured by the related parties but in
certain circumstances where tax authorities suspect tax evasion they may
insist to recharacterize a transaction for tax purposes. The OECD Guidelines
identify two exceptional situations where the recharacterization of may be
necessitated and insisted by tax authorities when : • the terms and conditions
of the transaction or series of transactions are such that arm’s length parties
would not have entered for commercial purpose • it can be reasonably
inferred by tax authorities that primary purpose of the transaction is not
normal commercial transactions but to avail tax benefit or tax evasion.

8.8 APPLICATION OF THE ARM’S LENGTH

PRINCIPLE
There are number of methods which when applied correctly can determine
the Arm’s length price. These methods are also known as “the recommended
methods” These methods are divided into two groups:

Traditional Transaction Methods:

• the comparable uncontrolled price ( CUP) method;
• the resale price method; and
• the cost plus method
• Transactional Profit Methods
• the profit split method; and
• the transactional net margin method ( TNMM).

Before choosing any method the tax payer should scan the environment for
decisive data which can justify the application of any method. The reliability
of any method depends on the availability of data and the accuracy which it
can generate for making necessary adjustments to achieve comparability. For
comparing transactions between related and unrelated parties (controlled and
uncontrolled transactions), taxpayer must ensure at least one of the following:
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Management that two transactions which are being compared have no differences between
Control Structure
them that would •tangibly influence the price in the open market; or, • in case
the tangible differences exist between the transactions than Decisive
Attunement can be done to nullify the tangible effects of such differences.
While applying any of the methods and providing allowance to factor in the
effects of phases of product life cycles and short-term economic conditions
on profit, taxpayer should consider multiple year data for: • the taxpayer for
whose transactions the transfer price is to be determine; and • the arm’s
length party whose transactions are treated as benchmark for establishing a
comparable. The OECD Guidelines, state that as far as possible traditional
transaction methods should be the primary methods of first choice and should
be preferred over the transactional profit methods. The option to use the
transactional profit methods shall be only exercised when application of
Traditional transaction does not yield reliable results and consequently
traditional transaction methods cannot be decisively applied or cannot be
applied at all. The transactional profit methods shall be methods of last resort.
The CUP method, if applicable, is capable of providing an elevated degree of
comparability among the traditional transaction methods because: • the price
of the transaction is the unit of analysis thereby eliminating one side bias; •
takes into consideration both functional and product comparability. The CUP
method is a straight forward and decisive means of establishing an arm’s
length price, but in certain circumstances other traditional transaction
methods may be preferred when: • quality information with regard to
uncontrolled transactions is not available or sparsely available; or •
quantification of differences between controlled and uncontrolled
transactions is not possible or not decisive. The main differences between
CUP method and the cost plus or resale price methods are:

In the CUP method the variable for analysis is the price of the transferred
property which includes goods and services whereas the cost plus and resale
price methods

Uses margins generated from resale of property or services. These margins

shall be in accordance with the functions performed by the reseller, assets
used for reselling, and risks assumed. The benchmark for the cost plus and
resale price methods is the gross margin level and as a consequence product
differences will have a minor impact on the reliability of the results as
compared to the CUP method. However the closer the products are in terms
of function and features the more decisive the result will be. The alternative
choice between the resale price method or the cost plus method is governed
by the fact that the data available should be of high quality and should be
comparable for each of the party to the transaction. The availability of
Quality comparable information is dependent on the complexity of the
transactions involved. For transactions which are of simple buying and
further selling nature the quality comparable information would be available,
but in case any value addition is done prior to further selling than it becomes
a complex transaction and data availability and comparability becomes a
256
complex exercise. For example, the resale price method may be the most Transfer Pricing

appropriate choice if the least complex party is a distributor. The tangible

differences in the transactions coupled with lack of comparable data or
absence of quality data will render cost plus or resale price methods useless
as the necessary adjustments required to make the transactions comparable
can’t be calculated. In these circumstances taxpayers will have to consider
the transactional profit methods The OECD Guidelines do not specify the use
of one transactional profit method over the other; as a matter of fact these two
transactional methods are considered as methods of last resort. However,
among the two transactional profits mentioned above application of profit
split method can produce a better and decisive estimate of an arm’s length
price as compared to the TNMM. Application of TNMM requires
establishing a high degree of comparability, including the comparability of
intangible assets (which is difficult to establish). The option to use any one of
these two methods will depend upon the ability of a particular method to
generate the highest degree of comparability between transactions.

Traditional Transaction Methods

Comparable uncontrolled price (CUP) method

The Comparable Uncontrolled Price (CUP) Method is based on the

comparison of the consideration/price charged for transferring property or
services in a controlled transaction (transaction between related parties) to the
price charged for property or services transferred in a comparable
uncontrolled transaction (transaction between unrelated parties) in
comparable circumstances.

A CUP method may be applied when an external and an internal comparable

can be easily computed. An internal comparable is computed from the price
at which the parent or affiliate of the group sells the particular product, in
similar quantities and under similar terms to arm’s length parties ( unrelated
parties) in similar markets. It can also be computed from price at which the
parent or affiliate of the group buys the particular product, in similar
quantities and under similar terms from arm’s length parties in similar
markets an external comparable can be computed from the price at which an
arm’s length party (unrelated party) sells the particular product, in similar
quantities and under similar terms to another arm’s length party ( unrelated
party) in similar markets. It can also be computed from price at which an
arm’s length party buys the particular product, in similar quantities and under
similar terms from another arm’s length party in similar markets .

One off sales or purchase by the parent or affiliate from an unrelated arm’s
length parties shall not be considered as an arm’s length price for the same
product transferred between related/non-arm’s length parties, unless the non-
arm’s length sales are also

One off. Transactions by unrelated parties (arms length transactions) can be

used even if there exists differences between these transactions and non- 257
Management arm’s length (related party) transactions, if:
Control Structure
• The differences can be measured on a reasonable basis; and
• These measured differences can be used to make adjustments to
eliminate the effects of differences.
The existence of differences between controlled and uncontrolled
transactions, will make it difficult to calculate the adjustments necessary to
eliminate the effect on transfer prices. These routine difficulties that arise in
making adjustments shall not impede the potential application of the CUP
method and taxpayers should make reasonable efforts to adjust for these
differences. . In a related party transaction the application of the CUP method
will not include an additional allocation of overhead cost and product
development cost to related parties except for if these costs are also included
in sales price for sales made to unrelated arm’s length parties. The CUP
method prevents the double deduction of those costs—once as an element of
the transfer price and once as an allocation.
Resale price method
In the resale price method we start with the computation of comparable gross
margin. The gross margins can be computed using external data or internal
data. The internal comparable gross margin is generated by analysing the
resale price margin earned by parent or affiliate in comparable uncontrolled
transaction that is the transaction with unrelated parties The external
comparable is generated by analyzing the resale price margin earned by an
unrelated entity in comparable uncontrolled transaction with another
unrelated party Under this method the resale’s price to arm’s length parties
(of a product purchased from a non-arm’s length enterprise) is first
determined. After that an appropriate comparable gross profit margin (the
resale price margin) is deducted from the resale price to arrive at arm’s length
price. As indicated above comparable gross margin is determined by
reference to either:
• The resale price margin earned either by parent or affiliates in
comparable uncontrolled transactions (internal comparable); or
• The resale price margin earned by an arm’s length enterprise in
comparable uncontrolled transactions (external comparable). Appropriate
gross margin is a subjective term and while deciding on appropriate
gross margin one should consider the following conditions so that the
gross margin, the resale margin, should reflect and be sufficient for the
seller to:
• recover its operating costs; and
• earn an arm’s length profit based on the functions performed, assets
used, and the risks assumed.
Due to the difference in product features and terms and conditions of
transactions the transactions may not be comparable in all ways and these
258 differences will have a tangible effect on price. In such circumstances the
taxpayer must make adjustments to nullify the effect of those differences. Transfer Pricing

This method will determine reliable estimate of an arm’s length price when
the transactions are similar in nature and the functions performed, risk
undertaken and assets used in the transaction are of comparable nature. When
an absolute monopoly is created by agreement between parent and affiliate
like an exclusive right to resell goods in particular market, this would be
usually reflected in the resale margin. The resale price method is Applicable
in cases where there is simple buy and resells transaction. In these kinds of
transactions there is no value addition or relatively very little value addition
to the commodities bought for the purpose of reselling. In case the seller adds
value to the products by further processing or by creation and maintenance of
marketing or manufacturing intangibles it would be difficult to determine
resale margin. In value addition cases this method will not be appropriate to
determine arms length price.

Cost plus method The starting point for the cost plus method is the
computation of the costs incurred by a supplier of a product or service.

The cost determination takes into consideration both the direct cost (material,
labour, etc) and indirect costs of production (factory overheads etc.). A
comparable gross mark-up is added to these costs to determine an arm’s
length price for services and products provided to a non-arm’s length
enterprise. This comparable gross mark-up is determined in two ways, by
reference to internal and external comparables. • internal comparables are
determined by the cost plus mark-up earned by a member of the group in
comparable uncontrolled transactions • external comparables are determined
by the cost plus mark-up earned by an arm’s length enterprise in comparable
uncontrolled transactions Irrespective of the comparables used , the returns
used to determine an arm’s length mark-up must be reflective of the
transactions performing similar functions and preferably for selling similar
goods to arm’s length parties. When the transactions are not comparable in all
respect and the differences manifest them in the form of tangible effect on
price, taxpayers must make adjustments to eliminate the effect of those
differences.

These differences may arise due to:

• The relative efficiency of the supplier; and
• Any advantage that the activity creates for the group

The more comparable the functions, risks assumed and assets used, the cost
plus method will result in an appropriate estimate of an arm’s length price .

In general, for purposes of applying a cost-based method, costs are divided

into three categories:

1. All direct costs such as raw materials, labour etc;

2. All indirect costs such as repair and maintenance, factory overheads
which may be allocated among several products; and 259
Management 3. Operating expenses such as selling, general, and administrative expenses.
Control Structure
Accounting principles and standards that are relevant for that particular
industry and generally accepted in country shall be used for calculation
of the cost. The cost base of the transaction of the tested party to which a
markup is to be applied shall be calculated in similar manner as the cost
base of the comparable transactions and shall reflect on similarity of
functions performed, risks undertaken and assets used for transaction.
The cost plus method uses margins calculated after taking into
consideration direct and indirect costs of production. Properly
determining cost under the cost plus method is critical as under or over
determination will deflate and inflate the margins. Where cost is not
accurately determined in the same manner, both the mark-up (which is a
percentage of cost) and the transfer price (which is the total of the cost
and the mark-up) will be misstated.

For example, if the comparable party includes a particular item as an

operating expense, while the tested party includes the item in its cost of
goods sold, the cost base of the comparable must be adjusted to include the
item.

The application of the cost plus method also requires careful consideration of
the relative efficiencies of the parties being compared. An analysis of
efficiencies includes a consideration of the differences in: • cost structures
(such as the age of the plant and equipment, labour efficiency, level of
automation, centralized purchasing etc); • business experience (such as start-
up versus mature businesses, experienced personnel’s with technical
knowhow etc); and • management efficiency. Where tangible differences
exist and are identified, the reliability of the comparables may be
compromised. Differences due to the capital intensity of the tested party and
an arm's length party will give rise to tangible differences in the transactions
for which adjustments cannot be made. The cost plus and resale price
methods are applied to only one party (the tested party) of the group
participating in the transaction. If the tested party on which the cost plus
method is applied is further contributing in value addition by way of further
processing or contributing in value addition through manufacturing,
marketing and after sales service intangibles developed by themselves, it
would be difficult to find comparable data to apply to this method. The
application of this method would become more challenging if the tested party
performs more complex functions, use additional assets and undertakes
additional risks. In view of this, the cost plus and resale price methods will
produce the most decisive results when:

• The functions performed by the tested party are the least complex; and

• The tested party does not contribute valuable or unique intangible assets.

Transactional Profit Methods: Traditional transaction methods are the most

decisive means of establishing arm’s length prices or allocations. With the
260
advent of global value chains (GVCs), the complexity of modem business Transfer Pricing

situations has increased substantially and this fact makes it difficult to apply
traditional transaction methods. In addition lack of information or non
comprehensive information on comparable transactions will also hamper
calculation of for adjustments allowance necessary to achieve comparability
for of a traditional transaction method. In such a situation taxpayers may have
to consider transactional profit methods. However, lack of information or non
comprehensive information shall not automatically lead to the adoption of the
transactional profit methods as the same factors are to be considered for
evaluating the reliability of a transactional profit method. The OECD
Guidelines endorse the use of two transactional profit methods:

• the profit split method; and

• transactional net margin method ( TNMM).

The main difference among these two methods is that the profit split method
is applied to all members involved in the controlled transaction, whereas the
TNMM is applied to only one member of the transaction which contributes
least value addition. The bedrock on which the successful application of
TNMM is based is the accurate comparability analysis. All the methods
which are based on comparability like the Cost plus and resale method are
likely to produce inappropriate results when uncertainty is associated with the
comparability analysis. In addition if the tested party contributes to value
addition or through unique intangible assets developed and maintained by it
uncertainty with regard to comparability will further increase as it is difficult
to find exact comparables for value addition and unique intangible assets.
Intangibles by their nature are often difficult to value, thereby making it a
challenge to calculate adjustments to account for the impact of the intangible.
In the presence of these uncertainties regarding comparability, if the tested
party chooses to apply TNMM, it is always appropriate to use a profit split
method to confirm the results obtained through application of TNMM.

Profit split method Under the profit split method the first step is to
determine the combined profit (or loss) arising from a controlled transaction.
In the next step the combined profit or loss that has arisen from the controlled
transaction between associated parties is split among the parties associated
with the transaction on an economically valid basis, based on the relative
value of their contributions to the non-arm’s length transactions, considering
the functions performed, the assets used, and the risks assumed by each non-
arm’s length party, in relation to what arm's length parties would have
received. Here two important points shall be kept in consideration: This
method only splits/allocate the combined profit of a controlled transaction,
not the total profits of the associated parties or group as a whole. The profit to
be split is generally the operating profit, before the deduction of interest and
taxes. In some cases, it may be appropriate to split the gross profit. Generally
one of the following three approaches are used to determine the appropriate
(arm’s length) Split of profits between associated parties to a transaction.
261
Management • Contribution analysis: In this method the associated parties are
Control Structure
allocated a part of the profit from the controlled transaction based on
their relative contribution to the combined profit. This split of profits
should be reflective of the division of the profits that would have been
agreed by arm’s length parties in uncontrolled transaction. . Few of the
economic variables which are used for deciding the contribution are
capital investment by each party in intangibles, labour cost and
bargaining power of each entity. • Comparable profit split: This method
is similar to the contribution analysis except for the fact that the profits to
be allocated between non arm’s length parties in the uncontrolled
transaction shall be determined with reference to one or more
comparable profit split transactions between arm’s length parties
engaged in comparable uncontrolled transactions.
• Residual Analysis: This method consist of two stages wherein in the first
stage profits are allocated for non unique (routine) activities by reference
to comparable uncontrolled transactions by unrelated entities and
thereafter in the second stage the remaining profit (residual profit) is split
on an economically valid basis. Comparable uncontrolled transactions
may be used as reference for residual profit allocation. The economically
valid basis and facts and circumstances include market value of
intangibles, capitalized, cost of developing and maintaining intangible
property or expenditure on intangible development. The profit split
method may be applied where:
• the transactions are difficult to evaluate on individual basis due to the
fact that the operations of two or more non-arm’s length parties are
highly integrated, i.e. where parent has developed manufacturing
intangibles and the subsidiary has developed marketing and after sales
service intangibles and
• The existence of valuable and unique intangibles makes it impossible to
establish the proper level of comparability with uncontrolled transactions
to apply a one sided method.

With the advent of global value chains and shifting of manufacturing to

developed countries and value addition in each and every stage of production
of products and services the complexity of multinational has considerably
increased .Since value creation is a multi step process with direct and indirect
contribution from both the parent and subsidiaries ,in light of this dynamics it
would be against the accounting principles to allow parent company or any
affiliate to lay exclusive claim on the total return generated from unique
assets such as intangibles. For example parent company produces a product
based on R&D efforts done by affiliate. The product is marketed in different
global locations by other subsidiaries using marketing and after sales
intangibles developed for that particular geographic location. In addition,
subsidiaries specially the ones listed on local stock exchanges would not in
normal course incur additional costs and risks to develop and maintain
262
intangible properties unless they expected to share in the potential profits. Transfer Pricing

When intangibles makes an impact on the price of the transaction and no

quality comparable data are available to apply the one sided methods (i.e.,
cost plus method, resale price method, the TNMM), taxpayers should
consider the use of a profit split method.

Transactional net margin method (TNMM) The application of TNMM

requires comparison of the net profit margin of a taxpayer arising from a non-
arm’s length controlled transaction with the net profit margins realized by
arm’s length parties from uncontrolled transaction and in addition it also
compares the net profit margin relative to an appropriate base such as
operating profit margin(EBIT/SALES),return on sales, return on total costs
also known as full cost markup FCM, Berry ratio, return on assets(ROA) and
return on capital (ROCE). The main difference between the TNMM and cost
plus and resale price methods is that in TNMM the net profit margin is
compared instead of gross profit margins as used in cost plus and resale price
method. As far as level of comparability is concerned TNMM, cost plus and
resale price methods requires a similar level of comparability. In case the
comparable information is present at the gross margin level, taxpayers should
prefer and apply the cost plus or resale price method. The TNMM is a one-
sided method and as with other one sided methods, it should be applied to the
least complex party that does not contribute too much value addition and is
not in possession of valuable or unique intangible assets. The TNMM relies
on a comparison of net margins. Therefore, a standard of comparability
similar to that needed for the cost plus and resale price methods must be met
if the TNMM is to produce a decisive estimate of an arm’s length result.
Application of the TNMM, like the cost plus and resale methods, requires a
careful evaluation of the functional differences. Where differences between
the taxpayer’s situation and that of one or more comparable entities exist and
can be determined, taxpayers must make appropriate adjustments to ensure a
high standard of comparability. Some differences may not lend themselves to
simple or decisive adjustments (e.g., differences in the age and productivity
of plant and equipment, management abilities or philosophies, and the
business experience of the respective entities). The failure to account for
these differences or to make satisfactory adjustments may preclude the
method from producing a decisive estimate of an arm’s length result.
Aggregated data compiled with respect to the profits within a particular
industry rarely satisfy the standards of comparability required to implement
the TNMM. Selection of an appropriate base such as sales, costs, or assets
employed, capital employed is critical to application of TNMM. Appropriate
base should be selected based on the nature of the business activity and facts
and circumstances of each case. . The taxpayers should follow a four-step
approach in their search for external comparable transactions under the
TNMM. The steps are as follows:

Step 1: Scan the environment for identifying and selecting an arm’s length
party operating in the same industry classifications as the tested party. Next
263
Management step in this process is to compare the products and functions of the selected
Control Structure
party. The more the resemblance in this aspect the more decisive the final
result would be

Step 2: This step involves analysis and comparison of transactions of the

selected entity and the tested party to determine if the comparable
transactions exist or not. This comparison is basically based on the financial
information available. For example, where the tested party is a manufacturer
with limited intangibles, the ratio of research and development expenses to
sales may highlight functional differences between the tested party and the
entities selected.

Step 3: Carefully examine all the financial and contextual information

available on parties selected in step1 and not weeded out in step [Link] is
required to determine whether the selected entity can be considered to have
comparable transactions. It is not necessary that the entities reported in a
similar industry code will have similar function and transactions as that of the
tested party.

Step 4: If tangible differences are there for the selected entity and the tested
entity, it may affect the comparability of the transactions selected in Step 1
and not weeded out by the testing in Step 2 or Step 3. In these situations,
calculate the adjustment factor where possible and eliminate any entities for
which necessary adjustments cannot be made. In many situations in spite of
following the hierarchy of methods taxpayer fails to establish an appropriate
degree of comparability. In such a situation, the taxpayer will be at liberty to
choose methods other than the recommended methods of OECD or tax
authorities of that particular country. The other methods selected shall satisfy
the arm’s length principle

Berry ratio

The Berry ratio focuses on profitability and operating expenses. By way of

illustration, consider the case of a parent company that has performed all the
R&D required to bring a product to market and has also manufactured the
product. The finished goods are sold to a related entity, which is responsible
for selling the goods. In this situation, the ‘simple’ entity is the selling entity
and the ‘complex’ entity is the manufacturer. The Berry ratio is sometimes
used to determine pricing between these types of entities and, at its heart, this
method is a cost plus method applied to selling entities. To compute the
Berry ratio, it is necessary to determine the mark-up that a typical distributor
earns on the selling, general and administrative (SG&A) expenses, which it
incurs. Specifically, the Berry ratio is calculated as the ratio of gross profit to
operating costs and is used to mark up the SG&A costs of the selling affiliate
in the intercompany transaction. All remaining income is attributed to the
manufacturing entity. The advantages of the use of the Berry ratio include the
ease of administration and the lack of concern for the size of the distributors
used as comparables. The difficulty with the method is that it typically
underestimates the amount of income that a selling entity should earn. This is
264 because the Berry ratio is essentially a cost plus method where gross profit
and operating profit are fixed as a percentage of operating costs. Selling Transfer Pricing

entities, however, typically earn gross profits that are fixed as a percentage of
their gross sales, not operating costs. SUMMARY Large business is usually
organized into divisions for effective management control. Apart from this as
the business spans from one country to another the business is organized as
parent company and subsidiaries. The individual operating units are rarely
self sustaining or independent; as a result transactions take place between
various independent units of the company. Transfer price is related with the
pricing of these transactions. Transfer prices are determined by the transfer
price policies used within the group. The transfer pricing policies of a group
are derived from the transfer pricing laws prevalent in that particular country
where the units are operating. The intra company transactions include various
financing transactions also apart from transaction of tangible and intangible
property. The OECD guidelines recommend a number of transfer pricing
methods that when applied correctly results in an arm’s length price
allocation.

8.9 SUMMARY
Large businesses are usually organized into divisions for effective management
control. Apart from this as the business spans from one country to another the
business is organized as parent company and subsidiaries. The individual
operating units are rarely self sustaining or independent; as a result transactions
take place between various independent units of the company. Transfer price is
related with the pricing of these transactions. Transfer prices are determined by
the transfer price policies used within the group. The transfer pricing policies
of a group are derived from the transfer pricing laws prevalent in that particular
country where the units are operating. The intercompany transactions include
various financing transactions also apart from transaction of tangible and
intangible property.

The OECD guidelines recommend a number of transfer pricing methods that

when applied correctly results in an arm’s length price allocation.

8.10 SELF-ASSESSMENT QUESTIONS

1. What do you understand by Transfer Pricing?
2. What do you understand by Transfer pricing manipulations? Explain the
micro 80 and macro level effect of Transfer pricing manipulations. 33
3. Explain the criteria used for establishing transfer price.
4. What are the various categories of intercompany transfer?
5. Explain the various modes used for transfer of intangibles.
6. Explain the concept of the Arm’s Length Principle.
7. Explain the traditional transaction methods for determination of transfer price.
8. Explain under what conditions the transactional profit methods are used
for determination of transfer price?
265
Management
Control Structure 8.11 REFERENCES
Horngren, Ch., Foster, G and Datar, S., Cost Accounting - A Managerial
Emphasis, Prentice-Hall, New York, 1994.
Malini, D., Divizionalno ra unovodstvo, Ekonomski fakultet, Beograd, 1997.

Polimeni, R., Fabozzi, F. and Adelberg, A., Cost Accounting, McGraw-Hill,

Inc., New York, 1991.
Liilja Antic, Vesna Jablanovic; Facta University Vol. 1, NS 2000 PP 61-70.

International Transfer Pricing; TIB Volume 12, No. 10, 2000.

Robert Turner, C.A. 1996 Study on transfer pricing Ernst & Young, Toronto.

266