Which types of responsibility centers generate both revenues and costs?

Types of Responsibility Centres:

Responsibility centres can be classified by the scope of responsibility assigned and decision-making authority given to individual managers.

The following are the four common types of respon­sibility centres:

1. Cost Centre:

A cost or expense centre is a segment of an organisation in which the managers are held re­sponsible for the cost incurred in that segment but not for revenues. Responsibility in a cost centre is restricted to cost. For planning purposes, the budget estimates are cost estimates; for control purposes, performance evaluation is guided by a cost variance equal to the difference between the actual and budgeted costs for a given period. Cost centre managers have control over some or all of the costs in their segment of business, but not over revenues. Cost centres are widely used forms of responsibil­ity centres.

In manufacturing organisations, the production and service departments are classified as cost centre. Also, a marketing department, a sales region or a single sales representative can be defined as a cost centre. Cost centre may vary in size from a small department with a few employees to an entire manufacturing plant. In addition, cost centres may exist within other cost centres.

For example, a manager of a manufacturing plant organised as a cost centre may treat individual depart­ments within the plant as separate cost centres, with the department managers reporting directly to plant manager. Cost centre managers are responsible for the costs that are controllable by them and their subordinates. However, which costs should be charged to cost centres, is an important question in evaluating cost centre managers.

2. Revenue Centre:

A revenue centre is a segment of the organisation which is primarily responsible for generating sales revenue. A revenue centre manager does not possess control over cost, investment in assets, but usually has control over some of the expense of the marketing department. The performance of a revenue centre is evaluated by comparing the actual revenue with budgeted revenue, and actual marketing expenses with budgeted marketing expenses. The Marketing Manager of a product line, or an individual sales representative are examples of revenue centres.

3. Profit Centre:

A profit centre is a segment of an organisation whose manager is responsible for both revenues and costs. In a profit centre, the manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits) for the department or division. The main purpose of a profit centre is to earn profit. Profit centre managers aim at both the production and marketing of a product.

The performance of the profit centre is evaluated in terms of whether the centre has achieved its budgeted profit. A division of the company which produces and markets the products may be called a profit centre. Such a divisional manager determines the selling price, marketing programmes and production policies.

Profit centres make managers more concerned with finding ways to increase the centre’s revenue by increasing production or improving distribution methods. The manager of a profit centre does not make decisions concerning the plant assets available to the centre. For example, the manager of the sporting goods department does not make the decisions to expand the available floor space for the department.

Mostly profit centres are created in an organisation in which they (profit divisions) sell products or services outside the company. In some cases, profit centres may be selling products or services within the company. For example, repairs and maintenance department in a company can be treated as a profit centre if it is allowed to bill other production departments for the services provided to them. Similarly, the data processing department may bill each of company’s administrative and operating departments for providing computer-related services.

An example of profit centres in a super market having different retail departments is displayed in Exhibit 11.3.

In profit centres, managers are encouraged to take important decisions regarding the activities and operations of their divisions. Profit centres are generally created in terms of product or process which has grown in size and has profit responsibility. In some organizations, profit centres are given complete autonomy on sourcing supplies and making sales.

However, in other organisations, such independence may not be found. Top management does not allow profit centre divisions to buy from outside sources if there is idle capacity within the firm. Also, the top management may be hesitant to part with designs and other specifications to maintain quality and safety of the product and due to fear of losing the market that the firm has already created for its products.

Benefits of Creating Profit Centres:

The creation of profit centres in a diversified or divisionalized firm has many benefits:

(i) Better planning and decision making—Profit centres managers are independent in managing the activities and are responsible for profit and success of their business units. This encourages them to make better planning, profitable decisions and exercise control. It creates a sense of accountability among the profit centre managers.

(ii) Participation in organizational plans and policies— Although profit centre managers are independent in the management of their business units, they function within the umbrella of overall organization. They get opportunities to participate in the discussion of plans and policies at the firm level. This widens their perspective and inculcates the habit of taking an integrated and macro view of activities in place of a narrow division specific view. In this process, profit centres managers can get trained to be the senior managers of their companies or other firms in the future.

(iii) Beneficial competitive environment—All profit centres managers target success and profit by managing costs and aiming higher revenues. This creates a competitive environment among the managers managing their respective business units which is not only beneficial for them but also contributes in achieving the overall objectives of the firm and in maximizing the firm profit.

Essentials of a Profit Centre:

The basic requirements of a profit centre are as follows:

(i) Operational autonomy:

Business unit managers should have sufficient freedom to take operating decisions on a profit-oriented basis, for example, regarding purchase, product mix, pricing and inventory. Unless they have sufficient autonomy to take decisions in respect of the above, the very purpose of delegating authority and treating profit as a measure of divisional performance would be defeated. Top management, therefore, must not impose its decisions on business unit managers. However, the decision taken by these divisional managers must be conducive to the achievement of the organisational objectives and policies.

(ii) Sourcing inputs and markets for products:

Business unit managers must have authority to source supply and markets to make profitable and sound make-or-buy decisions. Even if they are not permitted to actually purchase from external suppliers or from parties outside the organisation, they should be able to gain full information regarding demand and supply conditions and the prevailing and expected price trend in the industry.

(iii) Measurable costs and revenues of different profit centres:

The inputs and the outputs of the profit centres should be capable of separate measurement. By this, the need for apportionment of common input and output is minimised if not altogether eliminated. This makes it essential that the boundaries of different profit centres/divisions be clearly demarcated to preclude overlapping of activities. In the absence of well-defined boundaries and consequent overlapping of operations, unit managers may tend to take credit for everything that goes well and blame the other division for whatever goes wrong.

Also, it would be necessary not to include the corporate office and other administration costs, over which the business unit/divisional manager has no control, in the divisional profit performance reports. When the boundaries of the responsibility centres have a lot of overlapping operations/activities, managers are not adequately motivated to take decisions from the point of view of the likely impact on the profit of their unit.

(iv) Using profit as a measure of performance:

Although the contribution of a profit centre can not be measured solely by the amount of profit contributed by it, profit must be treated as the main measure of a business unit’s performance by the top management. If the top management does not give weightage to this, the divisional manager will tend to show less concern for this vital aspect of performance.

Since the business unit manager can boost profit by ignoring the need for repairs to plant and machinery or by deliberately reducing certain expenses, it would be necessary to use three or four non-profit measures of performance, for example, sales per employee, and production hours lost as a result of breakdown of machinery for evaluation.

(v) Size of profit centre:

Unless the division is large enough, it should not be treated as a profit centre. A small workshop or a section of a department, for instance, can not be regarded as a profit centre. There should be a sizeable amount of work being performed in the business unit for it to be under the charge of a senior executive such as a general manager or divisional manager who could be given decision-making powers and the responsibility for all its activities, including profit performance.

4. Investment Centre:

An investment centre is responsible for both profits and investments. The investment centre manager has control over revenues, expenses and the amounts invested in the centre’s assets. He also formulates the credit policy which has a direct influence on debt collection, and the inventory policy which determines the investment in inventory.

The manager of an investment centre has more author­ity and responsibility than the manager of either a cost centre or a profit centre. Besides controlling costs and revenues, he has investment responsibility too. ‘Investment on asset’ responsibility means the authority to buy, sell and use divisional assets.