Accounting: The Language of Business - Vol. 1 (Part 143)

There's real "right brain" creativity that goes into all of the organizational processes that a company utilizes and must continually reinvent in order to conduct its business. But there are also the "left brain" accounting functions that must continually ask how the company is doing financially and whether the creative processes are working for the bottom line.

John Kao

 Performance Evaluation for Decentralized Operations (Part B)

by

Charles Lamson

Responsibility Accounting for Cost Centers

In a cost center the unit manager has the responsibility and authority for controlling the costs incurred. For example, the supervisor of the Power Department has responsibility for the costs incurred in providing power. A cost center manager does not make decisions concerning sales or the amount of fixed assets invested in the center.

Some managers of cost centers have responsibility and authority over costs, responsibility accounting for cost centers focuses on costs. To illustrate, the budget performance reports in Exhibit 1 are part of a responsibility accounting system. These reports aid the managers in controlling costs.

EXHIBIT 1 Responsibility Accounting Reports for Cost Centers

In Exhibit 1, the reports prepared for the department supervisors show the budgeted and actual manufacturing costs for their departments. The supervisors can use these reports to focus on areas of significant difference, such as the difference between the budgeted and actual materials cost. The supervisor of Department 1 in Plant A may use additional information from a scrap report to determine why materials are over budget. Such a report might show that materials were scrapped as a result of machine malfunctions, improper use of machines by employees, or low quality materials.

For higher levels of management, responsibility accounting reports are usually more summarized than for lower levels of management. In Exhibit 1, for example, the budget performance report for the plant manager sometimes summarizes budget and actual cost data for the departments under the manager's supervision. This report enables the plant manager to identify the department supervisors responsible for major differences. Likewise, the report for the vice-president of production summarizes the cost data for each plant. The plant managers can thus be held responsible for major differences in budgeted and actual costs in their plan.

Cost centers may vary in size from a small department to an entire manufacturing plant. In addition, cost centers may exist within other cost centers. For example, we could view an entire university as a cost center, and each college and department within the university could also be a cost center, as shown in Exhibit 2.

EXHIBIT 2 Cost Centers in a University

Responsibility of Accounting for Profit Centers

In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits). Profit centers may be divisions, departments, or products. For example, a consumer products company might organize its brands (product lines) as divisional profit centers. The manager of each brand could have responsibility for product cost and decisions regarding revenues, such as setting sales prices. The manager of a profit center does not make decisions concerning the fixed assets invested in the center. For example, the brand manager of a consumer products company does not make the decision to expand the plant capacity for the brand.

Profit centers are often viewed as an excellent training assignment for new managers. For example, Lester B. Korn, the former Chairman and Chief Executive Officer of Korn Ferry International, offered the following strategy for young executives en route to top management positions:

Get Profit-Center Responsibility---Obtain a position where you can prove yourself as both a specialist with particular expertise and a generalist who can exercise leadership, authority, and inspire enthusiasm among colleagues and subordinates.

Responsibility accounting reports usually show the revenues, expenses, and income from operations for the profit center. The profit center income statement should include only revenues and expenses that are controlled by the manager. Controllable revenues are revenues earned by the profit center. Controllable expenses are costs that can be influenced (controlled) by the decisions of profit center managers. For example, the manager of the Men's Department at Nordstrom most likely controls the salaries of department personnel, but does not control the property taxes of the store.

Service Department Charges

We will illustrate profit center income reporting for the Nova Entertainment Group (NEG). Assume that NEG is a diversified entertainment company with two operating divisions organized as profit centers: the Theme Park Division and the Movie Production Division. The revenues and operating expenses for the two divisions are shown below. The operating expenses consist of the direct expenses, such as the wages and salaries of the division's employees.

In addition to direct expenses, divisions may also have expenses for services provided by internal centralized service departments. These service departments are often more efficient at providing service than our outside service providers. Examples of such service departments include the following:

• Research and Development

• Government Relations

• Telecommunications

• Publications and Graphics

• Facilities Management

• Purchasing

• Information Systems

• Payroll Accounting

• Transportation

• Personnel Administration

A profit center's income from operations should reflect the cost of any internal services used by the center. To illustrate, assume that NEG established a Payroll Accounting Department. The costs of the payroll services, called service department charges, are charged to NEG's profit centers, as shown in Exhibit 3.

Exhibit 3 Payroll Accounting Department Charges to NEG's Theme Park and Movie Production Division

Service department charges are indirect expenses to a profit center. They are similar to the expenses that would be incurred if the profit center had purchased the services from a source outside the company. A profit center manager has control over such expenses if the manager is free to choose how much service is used from the service department.

To illustrate service department charges, assume that NEG has two other service departments---Purchasing and Legal, in addition to payroll accounting. The expenses for the year ended December 31, 2023, for each service department are as follows:

An activity base for each service department is used to charge service department expenses to the theme park and movie production divisions. The activity base for each service department is a measure of the services performed. For NEG, the service department activity bases are as follows: 

Department                                      Activity Base

  Purchasing                              Number of purchase requisitions

  Payroll accounting                   Number of payroll checks

  Legal                                          Number of billed hours

The use of services by the theme park and movie production divisions is as follows:

The rate at which services are charged to each division are called service department charge rates. These rates are determined by dividing each service department's expenses by the total service usage as follows:

Purchasing: $400,000  / 40,000 purchase requisitions = $10 per purchase requisition

Payroll Accounting: $255,000 divided by 15,000 payroll checks = $17 / payroll check

Legal: $250,000 / $1,000 =  $250 per hour

The use of services in the Theme Park and Movie Production Divisions is multiplied by the service department charge rates to determine the charges to each division, as shown in Exhibit 4.

EXHIBIT 4 Service Department Charges to NEG Divisions

The Theme Park Division employs many temporary and part-time employees who are paid weekly. This is in contrast to the Movie Production Division, which has a more permanent payroll that is paid on a monthly basis. As a result, the theme park division requires 12,000 payroll checks. This results in a large service charge from Payroll Accounting to the Theme Park Division. In contrast, the Movie Production Division uses many legal services for contract negotiations. Thus, there is a large service charge from Legal to the Movie Production Division.

Profit Center Reporting

The divisional income statements for NEG are presented in Exhibit 5. These statements show the service department charges to the divisions.

The income from operations is a measure of a manager's performance. In evaluating the profit center manager, the income from operations should be compared over time to a budget. It should not be compared across profit centers, since the profit centers are usually different in terms of size, products, and customers. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 956-959*

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