mcs chapter6

8/2/2019 MCS Chapter6

1/24

this chapter we will discuss: Divisional Autonomy Responsibility Structure Responsibility Centers Performance Measurement of Decentralized Operations

Inter Profit Center Relations

An organization uses a number of structural elements to influence thebehavior of managers. These elements interact with the formal controlprocessto influence managerial behavior. These elements play an important roleininfluencing the autonomy of managers at the divisional control level, ofan

organization and also influence the way managerial performance ismeasuredand evaluated. This chapter focuses on the autonomy of managers atthedivisional level and the determinants of such autonomy. Such autonomycanbe categorized into three divisions- management style and process,responsibility structure and reward systems.DIVISIONAL AUTONOMYWith most organizations operating in dynamic and highly competitivemarkets, it is important for the top management to decide on the right

kind ofautonomy to be given to the managers. Organizations today requireflexibility,innovation and creativity. Thus, it becomes all the more important forthe topmanagement to decide on the levels of autonomy. The top managementmustdecide upon the level of decentralization of decision-making. To do this,thetop management should design a tool to help it attain congruencebetween the

levels of autonomy it wants to sanction to its subordinates and theextent ofautonomy that subordinates expect to get. Vancil1 developed a designtool thathelps the management to communicate the desired levels of autonomy.Thistool helps the management in designing structures and processes toachieve


2/24

the appropriate levels of autonomy. In this context, it is important todiscussthe variables that influence autonomy in an organization. The variablesdiscussed in the Exhibit 6.1 can be grouped into: Management style and process

Responsibility structure Measurement of reward systemsManagement Style and ProcessesManagement style plays an important role in influencing the behavior oftheemployees in an organization. Managers have different notions abouthow acompanys business can be run. They need to decide whether it can berun in acentralized manner or by striking a balance between centralized controland

decentralized action. All these constitute management style andprocess. Thereare a number of personal variables that influence the level of autonomythat acorporate manager can sanction a subordinate. These include: The level of involvement of the corporate managers in the business The interactions of the corporate managers with other managers The level of trust and confidence of the manager in the ability of thesubordinates1 Vancil, Richard F., Decentralization: Ambiguity by Design. Homewood,III: Dow Jones

Irwin, 1979.

Management style influences the decentralization process in anorganization. The companys plans, budgets, meetings, performancereviews, etc., are influenced by the managers style.Management policies and proceduresPolicies and procedures help managers decide the way in whichdecisions areto be made. They help in maintaining uniform behavior among profitcenter

managers with regard to certain decisions.Diversification strategyAccording to Vancil, there is a fair relationship between thediversificationstrategy that the management chooses and the autonomy of the profitcentermanagers. In firms that run a single business, the managers autonomyseem to


3/24

be restricted, whereas in firms that grow by acquiring or introducingunrelatedbusinesses, the extent of autonomy is high. When a firm runs a singlebusiness, all its functions are centralized which leads to the sharing ofExhibit 6.1

A Theory of Decentralized ManagementCORPORATE MANAGERSPhilosophy and StyleDIVERSIFICATIONSTRATEGYBreadth of Lines of BusinessBUSINESSSTRATEGYDefinition of MarketSegmentsIntended by Corporate

ManagersMANAGEMENT PROCESSPolicies and ProceduresAUTONOMYRESPONSIBILITYSTRUCTURECustody ofPhysical ResourcesCOST AND ASSETASSIGNMENTFor Shared Resources

Perceived byProfit CenterManagerMEASUREMENTMETHODSFor Assigned Costsand AssetsREWARDSPhysical andtangibleSource: R F Vancil , Decentralization:Managerial Ambiguity by Design,

( Dow Jones-Irwin,Homewood Illinios, 1979) 128.

resources and, thus, to restricted autonomy. When a firm runs a numberofunrelated businesses into unrelated businesses, there is not much


4/24

synergybetween the various businesses and only a few resources are shared.Thisleads to more managerial autonomy.Business strategy

Business strategy is the strategy to be followed in each division of theorganization. The kind of business strategy chosen by the managementinfluences autonomy in the organization. For example, a cost strategyleads toless autonomy as there is usually centralization of resources.The four variables discussed above-management style, processes,diversification strategy and business strategy have a major influence ontheautonomy of profit center managers. They constitute the first line ofinfluence that the top managers have over profit center managers.Responsibility Structure

The responsibility structure represents the physical, human and financialresources that are entrusted to the profit center manager. Theseresourcesrepresent the functional authority of the project center manager, andtheresources in the custody of a manager influences his/her decision-makingauthority. Responsibility structure can be considered the second line ofinfluence that the top management has over profit center managers.Theresponsibility structure and types of responsibility centers will be

discussed indetail later in this chapter.Measurement and Reward SystemsCost and asset assignments convey to the division manager those itemsof costand investment that the manager should be concerned about.Measurement methods show how much concerned the divisionalmanagersshould be about the costs and assets assigned. These methods help inallocating resources according to the requirement of a particulardivision. The

common methods of measurement are proration, negotiation andmetering.Proration refers to allocating resources based on standard rules of theorganization. Negotiating and metering give the managers moreautonomy indeciding upon the quality and quantity of resources they use.The reward system is determined on the basis of the performance of aparticular center. The amount and method of allocating bonuses


5/24

depends onthe managers autonomy. Rewards given to managers are eithertangible orintangible. Tangible rewards include financial and related compensation.Intangible rewards include power, status, and the feeling of

accomplishment.While responsibility structures are the second line of influence that thetopmanagement has over the profit center manager, the measurement andrewardsystem constitute the third line of influence.RESPONSIBILITY STRUCTUREThe responsibility structure of an organization consists of responsibilitycenters and related performance measurement systems. Theseresponsibility

centers work towards the achievement of the organizational goals. Thishierarchical placement of the responsibility center helps the topmanagementto ensure that decisions made in one part of the organization arecongruentwith decisions made in other parts. The responsibility structure includesanaccounting system. A responsibility accounting system helps managersto

record the plans and performances of the center for which the managerisaccountable. The measurement of the performance of a responsibilitycenter isdone through cost, profit, revenue, investment and quality goals set bytheorganization. There are three different methods of measuring theperformanceof a responsibility center. They are: The efficiency measure The process measure

Effectiveness measureThe efficiency measure measures performance in terms of inputsreceivedover a specified period of time for a given level of output. The processmeasure pertains to the production process, and the effectivenessmeasuregauges the output of the organization in terms of its goals andobjectives. The


6/24

above mentioned methods of performance evaluation help in assessingtheprogress of each subunit, and this is done with those variables for whichthemanager has reasonable amount of control in mind.

Overall Effectiveness Measures: Return on Investment (ROI)The most important objective of a firm is to achieve a good return oninvestment. The logic behind the hierarchy of responsibility centers andtheresponsibility accounting system is to make all the decentralizedsubunits ofan organization responsible for various elements of ROI. Theperformance ofresponsibility centers in an organization is based on cost, quality,revenue andinvestment.

Donaldson Brown of General Motors divided ROI into a number ofelementsfor easy understanding. These elements are helpful in establishingperformance measures for various subunits of a division that are goalcongruent and would have an influence over the performance measures.ROI= Net profit/invested capitalROI can be divided into two components- net profit, which is apercentage ofthe sales revenue, and the turnover of investments in relation to thesalesrevenue.

Profit margin = net profit/sales revenueInvestment turnover = sales revenue/invested capitalExhibits 6.2 and 6.3 show the computation of profit margin andinvestmentturnover.RESPONSIBILITY CENTERSResponsibility center is a unit or function of an organization headed by amanager who is directly responsible for its performance. In aresponsibility

center, the accounting system generates information on the basis ofmanagerial responsibility, allowing that information to be used directlyinmotivating and controlling the action of each manager in charge of aresponsibility center.Responsibility centers can be assigned very narrowly or broadly in termsof


7/24

the activities that senior management decides to assign to a particularmanager. But the type of responsibility center specifically defines theprimaryobjective of the decisions required when managing the assigned activity.For

example, as a cost center, a manager would focus on reducing costs inrelationto a standard cost or budget, and would not be concerned about theprofitmargins of the various products or the implications of these decisions onthecompany's profitability. However, in designating this center as a costcenter,the senior management should have already decided that the profitimplications would be controlled by another part of the entire system.Nature of Responsibility Centers

Every organization has its goals determined, and the managementdecidesupon the strategies to accomplish these goals. Responsibility centershelp inimplementing these strategies. As an organization is a collagium ofresponsibility centers, the ability of its responsibility centers to meettheirobjectives help an organization to achieve its goals. Every responsibilitycenter uses inputs (material, labor, etc.) and needs working capital,equipmentand other assets to function effectively. The responsibility center

producesoutputs which are classified as goods and services and hence they canbemeasured, whereas in human resources, transportation, accounting andadministration, the output is services that cannot be measured.Measurement of inputs and outputsIt is easy to identify the monetary costs of physical quantities. Theamount ofmoney is calculated by multiplying the physical quantity by a price unitofquantity. Therefore, the inputs of a responsibility center are referred to

ascosts. While the costs of inputs can be easily measured, outputs are notso easyto measure.Exhibit 6.2Computation of profit marginsales revenue cost of goods sold? +


8/24

net profit = operating expenses = period expenses? +other expensesincome taxesProfit margin =

sales revenueSource: Joseph A Maciariello and Calvin J Kirby, Management ControlSystems, (USA:Prentice-Hall Inc, Second edition) 194.

The performance of a responsibility center can be judged by using theeffectiveness and efficiency criteria. Efficiency is the ratio of outputs andinputs. These measures are usually used on a comparative basis. If

there aretwo responsibility centers, A and B, responsibility center A would beconsidered more efficient than responsibility center B if it uses lessresourcesthan B but has the same output, or if it uses the same amount ofresources, butproduces more output. If both the centers are found to be performing upto thecompanys expectations, the center that shows the lower costs isconsideredmore efficient.

The effectiveness of the unit is decided on the basis of a units outputsand itsobjectives. The greater the contribution of the outputs to theaccomplishmentof the organizational objectives, the more effective is the unit. A unitshouldbe both effective and efficient to contribute to the achievement of thesegoals.The companys overall profit can be considered as the base formeasuringeffectiveness and efficiency.

Types of Responsibility CentersAccording to the nature of monetary inputs and outputs, responsibilitycenterscan be classified into the following:Revenue centersRevenue centers are those organizational units in which outputs aremeasuredin monetary terms. These centers are marketing organizations and they


9/24

are notdirectly responsible for profits. Revenue centers are also called expensecenters, as the revenue center managers are held responsible forexpensesincurred by the unit. The main objective of revenue centers is to

maximizerevenues. For example, a marketing organization is a sales revenuecenter.Such a center is devoted to increasing the revenue, and assumes noresponsibility for production. In this center, the manager is responsiblefor thelevel of revenue or outputs of a center, measured in monetary terms,but is notresponsible for the costs of the goods or services that the center offers.Exhibit 6.3Computation of Investment Turnover

sales revenueF current assets+invested capital = fixed assets+Investment turnover = other assets+other liabilitiesSource: Joseph A Maciariello and Calvin J Kirby, Management ControlSystems, (USA:Prentice-Hall Inc, Second edition) 194.

Expense centersIn expense centers, inputs or expenses are measured in monetary termswhereas the outputs are not measured in monetary terms. There aretwo typesof expense centers-engineered expense centers and discretionaryexpensecenters. There are two types of cost involved in engineered expensecenters

and discretionary expense centers respectively-engineered costs anddiscretionary costs. Engineered costs are costs that can be estimated toareasonable extent by the management. Examples are direct labor anddirectmaterial. Discretionary costs, on the other hand, are costs that cannotbeestimated by the management.


10/24

Engineered expense centersIn these centers, inputs or expenses are measured in monetary termsandoutputs are measured in physical terms. These centers are usually foundin the

manufacturing units that use a standard cost system. There are certainresponsibility centers within administrative and support departmentsthatactually are engineered expense centers. In these centers, the cost oftheproduct is determined by multiplying the output of each unit with itsstandardcost. Its efficiency is measured by comparing the actual cost with thestandardcost.Discretionary expense centers

In discretionary expense centers, the output cannot be measured inmonetaryterms. Discretionary expense centers include administrative and supportunitslike legal, accounting, industrial and public relations units. Here, theefficiency is not the difference between budgeted and actual expense,but thedifference between the budgeted input and actual input. In discretionaryexpense centers the management decides on certain policies thatshouldgovern the company's operation. These relate to the amount of money

thatshould be spent on R&D, financial planning, public relations, etc. Thedecisions related to such activities depend on the way a companyoperates.Control characteristics for expense centersThe management control systems for expense centers are discussed,takinginto consideration factors like budget preparation, cost variability,financialcontrol and measurement of performance.Budget preparation: The decisions regarding the budget of expenses for

adiscretionary expense center is different from that for an engineeredexpensecenter. In engineered expense centers, the costs are determined by themanagement, taking into view the operating budget required to performthetask effectively in the future. However, in a discretionary expensecenter, the


11/24

principal task is to decide on the magnitude of the job that has to beperformed. These tasks are of two types-continuing and special.Continuingtasks take place year after year (like financial statements) while specialtasks

are one-time tasks, for example, developing a profit budgeting systemfor anewly acquired division.Management by objectives is a useful technique in preparing budgets foradiscretionary expense center. Management by objectives is a techniquewherethe objectives of performance are jointly determined by subordinatesand their

superiors. The progress towards these objectives is periodicallyreviewed andthe rewards are allocated on the basis of performance. Another methodused tounderstand the appropriate level of spending in a discretionary expensecenteris sensitivity analysis. According to this technique, the budget has asectionwhich explains the activities that can be undertaken if the budget isincreased.

Sensitivity analysis is mostly not taken by companies as they think thatit isimportant for a manager to prepare the possible budget foraccomplishingactivities that should be undertaken.Cost variability: The costs, in a discretionary expense center, tend tovaryfrom one year to another according to the volume. However, these arenotinfluenced by short-term fluctuations in volume within a year. Inengineered

expense centers, costs vary with short-term fluctuations in volumes.Financial control: The financial control in a discretionary expense centerisdifferent from that in an engineered expense center. Here, the operatingcostsare minimized by setting a standard for the costs and comparing theactualcosts with this standard. In discretionary expense centers, costs are


12/24

controlledby determining the tasks that have to be undertaken and the amount ofeffortthat is required for each task. Financial control is, hence, determined atthe

planning stage.Measurement of performance: The financial performance report of adiscretionary expense center does not help in evaluating the efficiencyof themanager, whereas in engineered expense centers the financial reporthelps inevaluating the efficiency of the manager. If the two centers are notproperlydistinguished, the management may consider the performance report ofadiscretionary center as an indication of its efficiency.

Administrative and support centersAdministrative centers include the senior corporate management, thebusinessunit management and the managers responsible for their staff units.Supportcenters provide services to other responsibility centers.Problems related to control in administrative and support centersincludedifficulty in measuring output, as they basically provide service andadvice tothe responsibility centers. Therefore, it becomes difficult to set cost

standards.Hence, their performance cannot be branded as efficient or inefficient.Secondly there is lack of congruence between goals of staff units andresponsibility centers. The suggestions that staff departments mayprovideregarding the development of systems, programs or functions may betoocostly when one thinks of the additional profits that these wouldgenerate. Theseverity of the problems is also related to the organizational level. At theoperational level, the staff activity is controlled by the plant manager,

and atthe business unit level, by the business unit manager. When comparedto theplant level, there is more discretion of tasks at the business unit level.Supportcenters charge a particular price for the services they provide to otherresponsibility centers.Budget preparation: The budget for a support center consists of


13/24

expenses, andis prepared by comparing with the current years actuals. This budgetconsistsof the following components- the basic costs of running a center (forwhich

there is no need of management decisions), costs incurred by thediscretionary

80

activities of the center, and a section containing proposed increases inbudget(other than those related to inflation).Research and development centersControl problems in research and development: The problems inresearch

and development are:Difficulty in measuring quality: The inputs for an R&D activity can bemeasured whereas the outputs are difficult to measure. For R&Dactivities, thetime taken for a particular research cannot be estimated as it may takemonthsor sometimes years for a particular activity. Also the output is difficult tomeasure because of its technical nature.Lack of goal congruence: As in administrative centers, goal congruencyislacking in R&D centers, too. Conflict may arise between the research

managerand the business unit manager. The research manager may want tobuild thebest research and development center, no matter what the expense be,while itmay not be possible for the company to afford it. Also, the researchersmaynot have sufficient knowledge about the business, in some cases.The research and development costs cannot be controlled on a year-to-yearbasis because a research project may take years to show results and the

organization would have to bear the cost of the project for that period oftime,mainly the cost on labor.Marketing centersThere are two types of marketing activities in every organization: orderfilling(logistics) and order getting. Order getting is an actual marketingactivity.


14/24

Order filling activities include transferring goods from the company tothecustomer, and receiving the appropriate pay from the customer. Thesearemostly engineered expense centers. Order getting activities include test

marketing, training sales force, advertising, sales promotion, etc.Though theoutput of a marketing organization can be measured, it is difficult toevaluatethe marketing effort, as the marketing department has no control overeconomic conditions or competitors actions. These actions may bedifferentfrom what was expected when the sales budgets were established. Insuchsituations, it is difficult to achieve management control. Also, it becomesdifficult to measure the efficiency and effectiveness of these costs.

Profit centersWhen financial performance of a responsibility center is measured interms ofthe organizations profit, then it is called a profit center. In a profitcenter,performance is measured in terms of the numerical difference betweenrevenues (outputs) and expenditure (inputs). A profit center is given theresponsibility of earning profits. It is involved in the manufacture andsale ofoutputs, and it measures how well the center is doing economically. Theprofit

center also determines the efficiency of the manager in charge of thecenter.A profit center helps in motivating managers to perform well in areastheycontrol and also encourages managers to take initiatives. The profitcenterhelps the organization to make the best use of specialized marketknowledgeof the divisional managers, and entrusts the local managers theresponsibilityof tradeoffs.

81

Profit centers have been used as a major management control tool. Themajoradvantages of profit centers are: These help in increasing the speed of making operating decisions asthey


15/24

do not have to be referred to corporate headquarters. As the decision-making authority lies with the managers they canmakebetter decisions related to the task they are performing, because theycan

understand the nature of the work better. Since profit centers make their day-to-day decisions themselvesheadquarters can concentrate on broader issues of the organization. Managers are motivated to perform more effectively, as they areresponsible for increasing the profit of their unit. Managers use their imagination, take initiatives to perform moreeffectively, to increase the profit of their unit.However, there are certain difficulties associated with the creation ofprofitcenters. The management cannot have considerable control over thedifferent

profit centers when decisions are centralized. The top management hastodepend on management control reports which may not be as effectiveas thepersonal knowledge of an operation. There may be no place forcompetentgeneral managers in a functional organization because of lack ofopportunitiesfor them to develop creative management skills.Organizational units compete with one another, and this may,sometimes,

result in conflict between different centers and reduction in cooperationbetween different units and sharing of resources.Types of profit centersFunctional units can be classified as different types of profit centers. Amultibusinesscompany can be divided into independent profit generating units suchas marketing, finance, manufacturing etc. The decisions regardingwhether aparticular functional unit can be a profit center depends on theresponsibilitycenter manager's ability to influence, if not control, other activities that

affectthe company's bottom line. The different types of profit centers arediscussedbelow:Marketing: A marketing activity becomes a profit center if it is chargedwiththe cost of the products sold. A marketing activity can be given theresponsibility of making profit when the marketing manager has the


16/24

authorityto make principal cost/revenue trade off in terms of marketing aproduct,spending on sales promotion, the appropriate time for this expenditureand on

which media to spend.Manufacturing: This is an expense center and the management ofactivitieshere is based on performance against standard costs and overheadbudgets.Problems in measurement may occur because of inadequate qualitycontrol,shipping of inferior quality products, and so on, to obtain standard costcredit.At times, there may arise the need to accommodate an order in-between

production schedules, and the manufacturing managers may bereluctant tointerrupt these schedules. In manufacturing units, when performance ismeasured against standards, there may be no incentives formanufacturingproducts that are difficult to produce. These factors may demotivate the

82

managers, and eventually, they may not try to improve standards.Hence,

while measuring the performance of manufacturing activities againststandardcosts, it is important to take into consideration quality control,productionscheduling and the make or buy decisions.Measuring profitability: Profitability measurements in a profit center canbe oftwo types-management performance and economic performance.Managementperformance focuses on the managers performance while economicperformance relates to how well a profit center is performing as an

economicentity. Management performance is a measure used for planning,controllingand coordinating the day-to-day activities of the profit center. Theperformance measures of profit centers can be different and hence, thenecessary purpose for the information should not be obtained from asingle setof data. For example, the management performance report can show


17/24

excellentperformance of a profit center manager. But the economic andcompetitiveforces for that particular report can show poor economic performance.As a

result, the center may run into losses and may even have to close shop.Types of profitability measures: The parameters that can be used formeasuring the profitability of a profit center are contribution margin,directprofit, controllable profit, income before taxes and net income.Contribution margin: This performance measure is used on the premisethat,since fixed expenses are not controllable by the manager, the focusshould reston maximizing the difference between revenues and variable expenses.The

problems of using contribution margin is that since many of the centersexpenses may vary according to the discretion of the profit centermanager,focus on the contribution margin tends to direct the attention of theprofitcenter manager away from the goals of the center.Direct profit: This measure helps in understanding the contribution oftheprofit center to the general overhead profit of the corporation. Itencompassesall the expenses directly incurred by profit centers or related to profit

centers,irrespective of whether the expenses are controllable by the profitcentermanager. However, it does not include corporate expenses.Controllable profit: The headquarters expenses in an organization can bedivided into two categories-controllable and uncontrollable. Controllableexpenses include expenses that are controlled by the business unitmanager.The advantage of including such costs in the measurement system isthat theprofit will be calculated after the deduction of expenses that can be

influencedby the profit center manager. Hence, these are controllable profits. Asuncontrollable headquarters expenses are taken into consideration whilecalculating controllable profits, controllable profits cannot be compareddirectly with published data or with trade association data, which reporttheprofits of other companies in the industry.Income before taxes: In this method, all corporate overhead profit is


18/24

allocatedto the profit center. The amount of expense incurred by each profitcenterforms the basis of allocation of profit. Such allotment has its owndrawbacks.

Firstly, the costs in departments like finance, and HR are not controllablebythe profit center and hence, profit centers should not be heldaccountable forsuch costs. Also, it is difficult to quantify the amount that has beenspent onhuman resources in each profit center.

83

However there are certain advantages in allocating costs.

Corporate service units often have a tendency to spend lavishly to maketheirunits as excellent as possible without paying due attention to the valuetheycreate for the company. Once such costs are allocated to profit centers,theprofit center managers will try to keep a check on the expenditure.The performance of profit centers is easily comparable to that ofcompetitorsperformance who pay for similar services.Since the profit center can earn profit only when it has recovered all its

costs,including allocated corporate overhead costs, the profit center managerwill bemotivated to make long-term marketing decisions such as pricing,productmix, and so on, because the center will have to recover its share ofcorporateoverhead costs.For profit centers to function with the allocated costs in mind, it isimportantthat they are allocated budgeted costs, and not actual costs. This

ensures thatthe profit center managers will perform without complaining about thearbitrariness of the allocated costs, since there would be no variances intheallocated overheads in the performance reports.Net income: The performance is measured by taking into considerationthe netincome after the payment of taxes. The disadvantage of using this


19/24

method isthat many decisions that have an impact on the income taxes are madeatheadquarters, and profit center managers should not be judged by thesedecisions. If the income after tax payment is constant percentage of the

income before tax payment, then there would be no need to measureperformance based on this method. This method would be useful if profitcenters influence decisions like installing credit policies or disposing ofequipment. This method is also useful to motivate the manager tominimizetaxes in case the taxable income differs from income, as measured byusinggenerally accepted accounting principles.The performance of profit centers can be measured by comparing actualresults with one or more of the measures discussed above withbudgeted

amounts. In addition, data on competitors and industry provide a goodcrosscheck on the appropriateness of the budget.Investment centersAn investment center has control over sales revenues and operatingcosts, andthe assets used to generate profit. An investment unit manager must bein aposition to influence the size of the investment and profit variables. Aninvestment center is a measure of economic performance, and itanalyzes allelements of profit and investment. The objective of this center is to

maximizeprofit, given the amount of investment required to generate the profit.Cost centersThe objective of cost center is to minimize the variance betweenstandardcosts and actual costs. A cost center is a production or service function,activity or item of equipment the costs of which may be attributed tocostunits. Cost centers are basically related to costs, and not to therevenues orassets and liabilities of the organization. A cost center is a separate

organizational unit for which separate cost allocation is done. A costcenter

84

forms the basis for building up cost records for cost measurements,budgetingand control. From a functional point of view, a cost center is a


20/24

production costcenter (where only production is undertaken like a assemblydepartment), aservice cost center (offering service to production departments likepersonnel,

accounting etc.,) or an ancillary manufacturing center (producingpackingmaterials).PERFORMANCE MEASUREMENT OF DECENTRALIZED OPERATIONSWhen a control system designer plans to measure the performance of adecentralized operation, a number of difficulties are encountered,especially ina multidivisional company. The main issues involved in themeasurement ofthe performance with regard to interdivisional transactions aremeasuring

profit and investment performance and setting transfer prices forinterdivisionaltransactions. The techniques for measuring performance discussedbelow like ROI performance measurement, transfer pricing are allsuitable forformal organizations. In informal organizations like a clan-based one,companies rely more on informal control mechanisms. The emphasishere ismore on teamwork.Measuring Divisional OperationsThe methods used to measure a divisional operation are based on the

responsibility structure and the cost and asset assignments of the firm.ROI- (Return on Investment) as a measurement of performanceThe objective of any firm is to achieve satisfactory returns oninvestment.Elements such as cost, quality, revenue and investment are assigned toaresponsibility center in appropriate amounts, and these elements areused tocalculate the ROI.The design of measurement systems and financial performance of a firmis

based on the principles of ROI. ROI is an important organizational issue.Eachresponsibility center should contribute to the ROI. The contribution ofeachcenter of an organization to ROI depends on allocation of resources tothecenter manager. Hence, ROI is an important investment criterion for theresponsibility centers.


21/24

To calculate the ROI of an investment center, it is important to definetherevenue, expense and investment allocated to the center. Expenses canbeassigned through cost assignment methods. Investment can be

assigned,depending on the assets to be assigned and the methods of measuringtheassets. When a firm applies a budgeted ROI figure to a responsibilitycenter todetermine expected profits, the divisional manager uses that figure as acriterion for investing in assets. These investments are made keeping inmindthe ROI budgeted figure. The ROI measure is important as it helps inestablishing corporate objectives and helps the managers to worktowards

achieving the organizational goals and investment projects that areappropriatefor the firm.The cybernetic paradigm helps in understanding the usage of ROI. Whenafirm functions within the goals of the organization in mind, and attains a

85

certain level of return on the total book value of the investment, thenthe

managers of the investment centers can be made responsible for ROI ascomputed in the divisional income statement and the balance sheet.INTER PROFIT CENTER RELATIONSResponsibility centers differ from one another in their activities andperformance. It is necessary to integrate the activities of the differentresponsibility centers. The performance measurement system should besodesigned as to encourage the divisional managers to act in the bestinterest ofthe company.One major problem encountered during the measurement of the

performanceof a division is the determination of prices for goods and services thataretransferred between divisions. This is referred to as the problem oftransferpricing.The problem of transfer pricing arises when the business conductstransactions


22/24

with each other. One solution to this problem is to stop businesstransactionsamong the divisions. However, this solution has some disadvantages. Ifthebusiness transaction between the divisions are eliminated, the

organizationwould have to forgo certain benefits, such as economies of scale inmanufacturing and management.Setting Transfer PricesTransfer price is defined as the value of transfer of services between twoormore profit centers. The transfer pricing system enables themanagement toenjoy the benefits of centralization and decentralization. Transfer pricesarenot set by the corporate staff; they are negotiated by the divisions

amongthemselves. The process of determining transfer prices is governed bytwocriteria-goal congruence and fairness.Goal congruenceA transfer price is said to be goal congruent if the buying and sellingdivisionsmake decisions regarding the price and quantity of transfers, whichwouldhave been the same if they were made by the central management.Fairness in setting transfer prices

This means that the profit center gives the divisional managers therequiredautonomy to pursue their objectives. In a profit center, where eachdivisionoperates almost as an independent company, one of the most importantdecisions that the managers need to take concerns the pricing ofproductsmanufactured by the division. The buying division usually negotiateswith theselling division to decide upon an appropriate price. However,disagreements

between divisions on transfer prices is a common occurrence.A transfer pricing system is said to be efficient if it encouragesmanagers topursue decentralization of autonomy and, at the same time, not forgothebenefits of centralization. It should allow the divisional managers toachievethe goals and objectives of the organization and at the same time these


23/24

goalsshould be in congruence with the organizational goals.

86

SUMMARYAssigning the right kind of to employees willresult in creative ideas. But a manager should be able to strike the rightbalance between autonomy and control. To understand autonomy, it isimportant to identify the variables that influence autonomy. They can begrouped under three heads: Management style and process,responsibilitystructure and reward systems. Management style, policies andprocedures,diversification and business strategy fall in the first group. Rewardsystems are

designed on the basis of the manager's ability to manage costs andinvestments. Responsibility structure consists of responsibility centersandrelated performance measurement systems. Responsibility structureestablishes the physical, human and financial resources that areentrusted tothe profit center manager. The availability of resources influences thedecision-making authority of the responsibility center managers.Responsibility centers can be classified into revenue centers, expensecenters,profit centers, investment centers and cost centers. Revenue center are

mainlyresponsible for raising the revenue, and assume no responsibility forprofits. Inexpense centers, inputs are measured in monetary terms, whereasoutputscannot be easily quantified. There are two types of expense centers:Engineered expense centers and discretionary expense centers.In profit centers, financial performance is measured in terms of thenumericaldifference between revenues and expenditures. An investment center isa

measure of economic performance and it analyzes all elements of profitandinvestments. Cost centers are supposed to minimize the variancebetweenstandard costs and actual costs. When divisional autonomy is providedtocenters, it becomes important to measure the performance ofdecentralized


24/24

operations. Factors ROI, are important for measuring performance.Managinginter-profit center relations is a major task in an organization. It isnecessary tointegrate the activities of the different responsibility centers so that they

worktowards the accomplishment of the goals of the organization.

mcs chapter6

Documents