Responsibility Accounting and Divisional Performance Measurement - 1 | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

Responsibility accounting has been integral to cost and management accounting for an extended period. It has gained widespread acceptance, particularly in the context of budgeting. It's important to note that responsibility accounting is not an independent management accounting system and doesn't entail any substantial alterations to accounting theory or generally accepted accounting principles. Instead, it constitutes one of the three categories of management accounting information, with the other two being full cost information and differential cost information. This unit will delve into the understanding of responsibility accounting, its system design, and its practical applications. Additionally, the module will cover performance evaluation for various segments and address the concept of transfer pricing.

The Concept of Responsibility Accounting

• Professor A.J.E. Sorgdrager developed the framework for responsibility accounting under the title "Particularisation of Indirect Costs." As implied by the title, responsibility accounting operates as a cost accounting system based on accountability. Accountability is established when actual results align closely with planned results, typically outlined in budgets and standards, resulting in minimal variances. Essentially, responsibility accounting functions as a method of budgeting and performance reporting structured around the organization's hierarchy. 
• Individual managers are held responsible for the costs within their designated areas, aiming to exercise control over operations. In simpler terms, it is a system that collects and reports accounting data based on managerial levels, defining accountability by identifying costs and the individuals responsible for them. Performance evaluation is conducted based on assigned responsibilities, and reporting follows the organizational structure with separate reports for each position on the organization chart.
• The core concept emphasizes the "personalization of costs" by investigating where costs were incurred and who bears responsibility for them. The technique focuses on cost control from the outset, aligning the accounting system with managerial accountability. Responsibility accounting involves organizing the accumulation, classification, measurement, and reporting of financial data to clearly attribute responsibility to the relevant manager. According to Horngreen, responsibility accounting directs attention to individuals rather than items, providing managers with information specific to their areas of responsibility. The key message is that every item, including income, operating costs, expenses, and capital expenditure, is the responsibility of a manager, leaving nothing unassigned.
• Responsibility accounting encompasses both historical and future costs. While some purposes express the activity of responsibility centers in historical amounts, others use estimated future amounts.

Profit Planning and Control (PPC)

• Responsibility accounting plays a crucial role in the budgetary system, facilitating the reporting of operating data and budget comparisons to individuals and groups with organizational responsibility. It assesses plans through budgets and evaluates actions based on the actual results of each responsibility center. When fully developed, responsibility accounting integrates seamlessly with the organizational chart, forming a built-in budgetary system. Budgets, serving as a measuring stick, allow for the judgment of actual performance when coupled with responsibility accounting, offering systematic assistance to managers who carefully interpret feedback.
• Taking an integrated and comprehensive perspective on budgeting transforms it into Profit Planning and Control (PPC). This involves planning and controlling desired or target profit figures through a series of budgets. Within this framework, responsibility accounting takes center stage, as control is its essence. Performance is evaluated using actual results. In contrast to traditional cost accounting, which primarily focused on determining the cost of products and services, responsibility accounting reverses this approach. Costs are no longer linked directly to products and services; instead, the emphasis shifts to addressing the planning and control needs of management. Initially, costs are accumulated for control purposes, and subsequently, they are recalibrated for product costing purposes. The control aspect is underscored by summarizing and reporting costs based on individual responsibility before consolidation for product cost purposes occurs.

Design of the System

When designing a system, decisions regarding its structure and processes are essential, and the same applies to responsibility accounting. The structure of responsibility accounting is built upon responsibility centers, and the process involves categorizing costs into controllable and non-controllable groups, implementing flexible budgeting, and conducting performance reporting. These components, constituting the principles or fundamentals of responsibility accounting, are discussed below:

Establishing Responsibility Centers

A responsibility center (RC) is an organizational unit formed based on specific functional activities for which individual managers are held accountable. The first step in implementing responsibility accounting is the establishment of responsibility centers. In a large decentralized organization, restructuring occurs in terms of areas of influence, categorized in ascending order of autonomy as cost centers, revenue centers, profit centers, and investment centers. The extent to which responsibility accounting is applied depends on the delegation of authority and assignment of responsibility.

• In a cost center, the manager is accountable solely for the costs (expenses) incurred in their sub-unit. Variances between actual and budgeted costs require an explanation from the manager.
• In a revenue center, the manager is responsible for generating revenues up to the budgeted levels.
• In a profit center, the manager assumes responsibility not only for costs and revenues but also for profit performance. For example, the manager of a furniture department in a departmental store is expected to earn the budgeted profit from furniture sales.
• In an investment center, the manager has control and responsibility over the assets used in their activities. For instance, individual departments in a departmental store or branches in a chain store are considered investment centers, and the manager is expected to achieve a target rate of return on investment.

It is crucial to note the distinction between an investment center and a profit center. An investment center is evaluated based on the rate of return earned on the assets invested in the sub-unit, while a profit center is assessed based on the excess of revenue over expenses for the period.
Control is effective when exercised through managers responsible for the organization's actions, following the principle that a manager's performance should be assessed based on factors within their span of control. Each manager's budget includes costs and revenues within their sphere of control, typically accumulated by departments. Subsidiary revenue and expense accounts are established for each center, allowing accounting transactions to be recorded by both category and responsibility center. This enables the accounting system to summarize transactions for public reporting by descriptive category and for performance evaluation by responsibility center, showcasing costs at different reporting levels within the organization.

Limits to Controllable Costs

• After establishing responsibility centers within a company, it is crucial to identify costs and revenues that fall under the control of each center. In responsibility accounting, the classification of costs is based on controllability, referring to the manager's ability within a responsibility center to influence (increase or decrease) them. 
• Costs are categorized into controllable and non-controllable groups. Controllable costs are those that the head of the responsibility center can change through managerial actions, such as regulating quantity or price. Uncontrollable costs, on the other hand, cannot be altered within a specific time frame at the discretion of the manager but may be subject to change at higher levels of management authority. 
• Typically, costs like raw materials, direct labor, and operating supplies are considered controllable, while fixed costs such as rentals, depreciation, and equipment insurance are non-controllable. In this framework, there is no allocation of common or joint costs, as the allocation process is considered arbitrary due to the indirect nature of such costs.

Flexible Budgeting

• Responsibility accounting assumes flexible budgets, prepared for various levels of activity rather than a static level. When actual output is obtained, a new budget is prepared accordingly, and the comparison of actual results is made against the freshly prepared budget targets for that level of activity. Using a budget based on a different level of activity than the actual one is deemed a weak analysis. 
• A performance budget is essentially the flexible budget adjusted to the actual level achieved. Flexible budgeting allows for the comparison of actual costs with budgeted costs adjusted for changes in production volume. Flexible budgets can be prepared using either the mathematical function or formula method or the multi-activity method.

Performance Reporting

• Each responsibility center is required to provide periodic performance reports, encompassing both financial and statistical components. These reports detail income, expenses, capital expenditures, and relevant statistics like production volume, cost per unit, and manpower data. Performance reports typically highlight actual costs incurred, budgeted costs, and variances, representing the difference between actual and budgeted amounts. 
• Summaries are usually provided for the reported month and the current year-to-date. The purpose of these reports is to prompt timely and corrective action. The frequency of performance reports can vary, being monthly, weekly, or even daily, depending on the organization's size and the significance of the information. It is essential that the information is delivered to managers while still useful, as reports received weeks after the period may have limited value. Furthermore, once performance reports are prepared, management can focus on addressing significant variances from the budget, a practice known as management by exception.

Difficulties

While responsibility accounting is a conceptually attractive tool for motivation and control, many organizations face challenges in realizing these objectives. Two primary difficulties in successfully implementing a responsibility accounting system are the accumulation of a large volume of data and the development of appropriate performance measures.

• Accumulation of Data: One significant challenge is the accumulation of a substantial amount of data, especially when detailed information needs to be collected throughout an organization. However, advancements in technology, particularly the use of computer-based cost accounting systems, have made the practical implementation of cost accumulation at a detailed level feasible. Computer programs can efficiently summarize costs for each descriptive category, aiding in product costing and generating traditional income statements. These programs can also aggregate costs by responsibility centers, facilitating the creation of associated performance reports. While data accumulation remains a considerable challenge, the use of computer technology has mitigated this problem to a large extent.
• Development of Appropriate Performance Measures: The more complex challenge lies in the development of suitable performance measures. For a budgetary system to effectively serve as a control mechanism, managers must adopt and embrace cost and revenue goals as individual objectives. This acceptance is more likely when budgeted goals are perceived as reasonable, realistically attainable, and yet challenging. The role of the cost accountant is crucial in identifying these performance measures and isolating the costs incurred in each responsibility center. It is essential to categorize these costs as either controllable or uncontrollable before establishing the reporting structure. Decisions made in this regard significantly impact the effectiveness of the responsibility accounting system.

In general, responsibility accounting systems are often employed in conjunction with standard costs. A major responsibility for the cost accountant is the development and subsequent interpretation of these standards to ensure effective implementation and performance evaluation.

Uses of Responsibility Accounting

Responsibility accounting, which emphasizes managerial levels, plays a vital role in the management control process, offering various uses and significant benefits.
These advantages are outlined below:

• Performance Evaluation: One of the primary benefits is the ability to evaluate individual managers based on cost performance. Localizing responsibility enables the rating of managers, encouraging extra vigilance as they are held accountable for their actions. The information provided by responsibility accounting assists in controlling operations and assessing the performance of subordinates.
• Delegating Authority: Responsibility accounting inherently facilitates proper delegation of authority. Its focus on decentralization of power serves as a key point, leading to effective delegation within large business firms.
• Motivation: Responsibility accounting utilizes accounting information for planning and control, motivating managers to achieve set targets. The awareness of being evaluated prompts managers to invest effort in meeting their goals, acting as a powerful stimulus. The system is built on the idea of motivating individual managers for maximum performance.
• Corrective Action: In cases of unsatisfactory performance, identifying the responsible individual is crucial for corrective action. Responsibility accounting, by clearly defining areas of authority, simplifies the process of taking corrective measures. Effective control actions must be implemented immediately after identifying the causes of problems to minimize unfavorable financial effects.
• Management by Objectives: The system involves assigning specific objectives to heads of divisions and departments before the period begins, holding them accountable for achieving these targets. Shortfalls are penalized, and excesses are rewarded, contributing to the establishment of the Management by Objectives (MBO) principle.
• Management by Exception: Performance reporting in responsibility accounting focuses on exceptions or deviations from the plan. This concept runs throughout the system, enabling managers to concentrate their efforts on major variances with the greatest potential for improvement. The success of the system lies in the concentration of managerial attention on exceptional or unusual deviations rather than on all deviations.
• High Morale and Efficiency: The clear link between rewards and performance acts as a morale booster. When it is evident that rewards are tied to individual performance, disappointment is minimized, especially when an operating foreman is evaluated based on decisions in which they were actively involved. This linkage enhances morale and efficiency within the organization.