This chapter expands on the topic of responsibility begun in earlier chapters, defining the types of responsibility center and how each is evaluated. It discusses both financial and non-financial measures of performance. The financial ratios used should be a review for you, since you have used them in more than one previous course.
Decision-making in a decentralized organization is spread throughout the different levels of management.
Advantages of decentralization include:
Top management time is freed from day-to-day decision-making to focus on major issues such as long-term strategy.
Lower managers have the best information for day-to-day operating decision.
Lower managers are closer to routine operations and can provide faster response time to problems.
Lower managers learn decision-making by given this responsibility, preparing them for upper management positions.
Managers are better motivated, and have more job satisfaction, if they are given the ability to make decisions affecting their area.
Disadvantages of decentralization may be (although it is possible to control them):
Lower level managers lack understanding of “the big picture” for the organization.
When all managers are making independent decisions about their own areas, some coordination of company activities may be lost.
A lack of goal congruence could result: a decision made by a manager that benefits that one area, may not benefit the company as a whole.
The spread of ideas may be limited by compartmentalization.
A responsibility center is any part of an organization whose manager has control over cost, profits, and/or investments.
Cost center: the manager control costs, but not any revenues or invested funds.
Evaluation based on standard costs, flexible budget, variances.
Profit center: the manager controls costs and revenues, but not invested funds.
Evaluated based on profits (so, both costs and revenues must be controlled) versus budget.
Investment center: control over costs, profits and invested funds.
Must control all three: costs, revenues, invested funds.
Evaluated based on ROI or residual income.
A segment is any part of the company about which management wants cost, revenue or profit data.
Segmented income statement:
Separate costs that are attributable (traceable) to the segment from those that are not.
Separate fixed and variable costs; separate fixed costs into traceable and common costs.
Contribution margin format.
= Contribution margin (use for decisions involving temporary use of capacity)
Traceable fixed costs (would disappear over time if the segment disappeared; avoidable; incurred because of the segment)
= Segment margin (best gauge of long-term profitability)
Common fixed costs (not allocated to segments, listed only with “company” or higher-level-segment total; support more than one segment; not changed by the elimination of one segment)
= Net operating income
QUOTE TO NOTE: Page 426: “Any allocation of common costs to segments reduces the value of the segment margin as a measure of long-run segment profitability and segment performance.”
ABC-allocated fixed costs: although this is, as you learned, a very accurate method of matching costs and cost drivers to the products that cause them, the question still remains about the avoidability of the costs you’ve allocated. To the extent that there are fixed costs involved, reducing a cost driver volume may not reduce the cost. Traceable is NOT necessarily avoidable.
A cost that is traceable to a segment at one level may become a common cost when that segment is further broken down into smaller segments. Traceable and common are relative, not absolute terms.
Common errors in cost assignment that reduce the value of the segment margin:
Omission of some costs: particularly, selling and administrative costs are not traced (instead, allocated using a general cost driver) to products when absorption costing is…