RESPONSIBILITY ACCOUNTING

Responsibility Accounting describes the decentralisation of authority with performance of the decentralised units measured in terms of accounting results.

Responsibility Accounting recognises various decision centres throughout an organisation and trace costs, revenues, assets and liabilities to the individual managers who are responsible for making decisions about the costs in question.

It is a ‘ system of accounting that segregates revenues and costs into areas of personal responsibility in order to assess the performance attained by persons to whom authority has been assigned’.

Accounting reports are provided so that every manager is aware of all the items which are within his/her area of authority so that he is in a position to explain them.

There are three responsibility centres or units. A responsibility centre is’ a unit or function of an organisation headed by a manager having direct responsibility for its performance’.

Type of unit	Manager has control over	Performance Measurement
Cost centre	Controllable costs	Variance Analysis,
		Efficiency measures
Profit centre	Controllable costs	Profit
	Sales volume/prices
Investment centre	Controllable costs	Return on Investment
	Sales	Residual Income
	Investment in fixed/ WC assets	Other financial ratios

Cost centre: ‘a location function or item of equipment in respect of which costs may be ascertained and related to cost units for control purposes’.

Profit centre; ‘a segment of the business entity by which both revenues are received and expenditures are caused or controlled, such revenues and expenditure being used to evaluate segmental performance'’

The manager of a profit centre is made accountable and responsible for the profits achieved. The manager should be able to make decisions which may improve profitability. In organisations where power is centralised the individual manager may not have autonomy to make these decisions.

Investment centre: ‘ a profit centre in which inputs are measured interms of expenses and outputs are measured in terms of revenues and in which assets  employed are measured – the excess of revenue over expenditure then being related to assets employed’.

The investment centre or divisional manager is allowed discretion about the amount of investment undertaken by the division so profit measurement alone is not sufficient to measure performance. Profit should be related to the capital employed in the division.                                                                                                                                                       

Divisional Management Performance

There are two main performance measures for divisions –  Return on Capital Employed or Risidual Income.

ROCE or ROI is a relative statistic it looks at the relationship between profitability and capital employed.

                                                Net Profit/ Net Investment in Assets

ROI can be used in two ways.

(1)                 As a control technique to compare divisional performance within a company.

(2)                 As a planning decision technique to decide to accept or reject projects

ROI can be looked at in two ways:

                ROI  =   Net profit / Net investment in assets

OR

               

ROI =             Net profit       x                    Sales

                         ----------------                  ------------

                           Sales                              Net assets

ROI is not only a function of profitability but is also a result of asset utilisation

It is essential that when the ratio is used for comparison purposes that the same accounting rules and procedures are used to arrive at profit and capital employed.

Management action	Effect on ROI
Reduce level of costs	Improvement  in
Increase profit mark up on sales	Profit element
Reduce net assets employed	Improvement in
Increase level of sales	Asset use element

Advantages

(1)                 It is regarded as one of the prime performance measures

(2)                 It deals with profit and net assets which are concepts  well understood in business.

(3)                 Useful for comparison of one business unit with another provided the same accounting rules are used.

Limitations

(1)           Can lead to sub-optimal decision-making. A manager will be unwilling to accept  projects and investment opportunities which do not produce a ROCE equal or better to the current ROCE being earned by that division. (See overhead)

(2) Care has to be exercised in terms of how the ROCE is calculated.

                      Net profit/ Capital employed

Net profit, Controllable contribution, Contribution.

Capital employed – net total assets, intangible assets?, leased or hired assets

(4)               There can be manipulation of the ratio. It can lead to an emphasis on  short-termism in respect to the profit figure. The total asset figure can be manipulated- a reluctance to invest in new assets, lease rather than buy assets.

(5)             

Limitations of ROI

The main drawback with ROI is it can lead to sub-optimal decision-making. If a divisional manager’s performance is to appraised by ROI he/she will be unwilling to accept projects which do not realise a return at least equal to the current ROI being earned by that division.

EG.  A divisional manager has investment in assets standing at £4 million with a current return of £800,000 profit. A new investment opportunity presents itself. The investment would involve £1.6 million with an estimated £240,000. The manager’s performance is determined by ROI.

Would the manager accept the project?

	Current position	New project	New position
	£’000	£’000	£’000
Investment level	4,000	1.600	5,600
Income from investment	800	240	1,040
ROI	20%	15%	18.6%

The manager would be inclined to reject the project since it would dilute the ROI. Let’s suppose the company’s overall cost of capital is 10%. Any project which delivers a return in excess of 10% increases the wealth of the company.  This is sub-optimal planning and decision-making.

Net Residual Income

Whereas ROI is a relative measure RI is an absolute income measurement. The decision rule is if a new  investment project generates a positive return in excess of the company’s cost of capital should be accepted by divisions within the organisation.

The RI works by charging divisions with an imputed interest charge equal to the organisation’s cost of capital. Any new projects giving a surplus of income after being charged interest or rent should be accepted.

Using the same information as before:

	Current position	New project	New position
	£’000	£’000	£’000
Investment level	4.000	1,600	5,600
Income from investment	800	240	1,040
Less interest charge @ 10%	(400)	(160)	(560)
	---------	---------	--------
NRI	400	80	480
	======	=====	=====

The manager would accept the project since his divisional and the company’s residual income is increased after a notional rent or interest is charged for the use of assets.

Standard Costing

Standard costing is a management control system which is to be found in manufacturing industry in particular. Just like budgetary control, standard costing is also part of the control system. Both use variance analysis. Standard costing is a unitary concept ie. it uses standard material cost or standard labour cost. Budgeting, on the other hand uses these unit standard costs to compile total costs eg. material costs or labour costs.

Variances represent the differences between standard costs and actual costs. The standard cost is what the cost is estimated to be and this is compared to what the cost is actually.

Variances are classified as favourable if the actual costs are less than the standard costs and profit is increased as a consequence. Adverse variances decrease profits. Some variances may be controllable if the individual manager can influence the actual costs.

Some organisations operate on the principle of management by exception. The accountant presents an exception report which highlights the significant variances. This means management need only investigate certain variances which lie outside set tolerance levels.

A Standard cost is defined as ‘ a pre-determined cost calculated in relation to a prescribed set of working conditions, correlating technical specifications and scientific measurements of materials and labour to the prices and wage rates expected to apply during the period to which the standard cost is expected to relate, with an addition of an appropriate share of budgeted overhead’. It is a cost worked out in advance of production of the expected cost of a product or service.

Advantages of Standard costing

1                    It provides management with a consistent method of comparing actual performance with planned performance.

2                    It provides a means of ensuring that prodution resources are purchased and used efficiently.

3                    In establishing standards management can examine and appraise existing practices and procedures to ensure cost-effectiveness and efficiency.

4                    It can inculcate cost-conciousness in the staff.

5                    It helps to motivate staff by setting realistic standards.

6                    Using variance analysis performance ca be monitored and improvements in work methods can result.

Types of Standard

·      Ideal standard - assumes perfect production conditions with no mechanical failure, no stock-outs, no staff absenteeism etc. It is unattainable but is an indication of what to strive for.

·      Attainable standard - is a realistic target and is based on efficient working conditions with allowance made for machine breakdown , stockouts etc.

·      Basic standard - is a standard set for use over a long period of time and is used to compare with current standards to to see the effect of changes in conditions over the years.

·      Current standard - is set to reflect current conditions so has limited use in time. In times of inflation such standards may be set monthly.

Variance Analysis

Direct Material Variance

The main reason for actual and estimated costs being different are either a change in the price of materials or a change in the usage of material.

1                    Materials price variance is the difference in cost that results from the price being different to the standard.

            ( Standard price - Actual price ) x Actual material usage

2          Materials usage variance is the difference between the actual usage of   material and the standard usage multiplied by the standard price.

            ( Actual usage - Standard usage ) x Standard price

3          Total material variance = Actual Material cost - Standard Material cost

Direct Labour Variances

1                    Labour rate variance is the difference between the actual wage rate and the standard rate of pay times the actual hours worked.

            ( Actual - Standard rate of pay ) x Actual hours worked

2          Labour efficiency variance is the difference between the actual hours   worked and the standard hours ie. the hours that should have been             worked to produce the actual output.

            ( Actual hours - Standard hours ) x Standard rate of pay

3          Total labour variance = Actual Labour cost - Standard L abour cost

Variable Overhead Variances

1                    The variable overhead variance is the difference between the variable overhead cost actually incurred and the cost which should have been incurred for the actual hours worked. This assumes that variable overheads are directly attributable to labour hours.

2                     

            Actual expenditure - ( Standard hours worked x Variable Overhead rate )

2          The variable overhead efficiency variance is the difference between the amount of overheads recovered based on the standard hours of production and the amount which should have been recovered if the actual hours worked had been at standard efficiencey.

            ( Actual hrs. worked - Standard hrs. worked ) x Variable Overhead rate

3          Total Variable O’H Variance =  Actual  Variable O’H cost - Standard  Variable O’H cost

Fixed Overhead Variances

1                    The fixed overhead expenditure variance is the difference between the expenditure actually incurred and that actually budgeted.

            Actual expenditure - Budgeted expenditure

2          The fixed overhead volume variance measure the amount of any under or over recovery of overheads due to actual output ( measure in terms of standard hours of actual production ) being different to that budgeted.

           

            Total Fixed Overhead Variance = Actual Cost - Standard Cost

Sales Variances

1                    The sales margin price variance gives the effect on profits of a change in selling price.

            ( Actual price - Standard price ) x Sales volume

2          The sales margin quantity variance is the difference in profit which results from a change in the sales volume.

            ( Actual sales - Budgeted sales ) x Standard profit margin

3          Total Sales Variance = Actual Sales - Standard Sales

Problems with Standard Costing

1                    Standard setting is a lengthy and costly procedure.

2                    Standards are often seen by the staff as restrictions on their behaviour which can lead to dysfunctionalism.

3                    Reporting variances may not be timely, cost effective and encourage managerial response.

4                    Standards invariably produce variances some of which may not be controllable eg. material prices which can result in unnecessary reporting and investigation.

5                    Standard costing may be inappropriate for certain kinds of manufacturing eg. Just-in- Time.

Example

A company X Ltd. produces a single product. The standard cost per unit and the actual results for a 4 week period are as follows:

Standard Costs		Actual Costs
	£		£
Direct Materials (1 kilo)	10	Sales	319,000
Direct Labour (2 hours)	10	Direct Materials
Variable Overheads	2	11,200 kilos @ £9.8	109,760
Fixed Overheads	5	Direct Labour
		21,000 hours @ £5	105,000
Standard Cost	-------------- 27	Variable Overheads	21,500
Standard Margin	3 ---------------	Fixed Overheads	52,000 --------------
Standard Selling Price	30 ---------------	Net Profit	30,700 ---------------
Budget output for the month 10,000 units		Actual output 11,000 units

Solution

Materials Price Variance

                        ( SP - AP ) x AQ

                        ( £10 - £9.80) x 11,200 kilos = £2240 (F)

Materials Usage Variance

                        ( SQ - AQ ) x SP

                        ( 11000k - 11200k ) x £10 = £2000 (A)

Labour rate variance

                        ( SR - AR ) x AH

                        ( £5 -£5 ) x 21000hrs. =   0

Labour efficiency variance

                        ( SH - AH ) x SR

                        ( 22000hrs. - 21000hrs. ) x £5 = £5000 (F)

Variable Overhead Variance

                        ( Actual expenditure - ( Hrs. worked x VOAR)

                        ( £21500 - ( 21000hrs. x £1 ) = £500 (A)

Variable overhead efficiency variance

Overhead actually recovered - Overhead recovered at standard labour efficiency

                        (22000 x £1 - 21000x £1) = £1000 (F)

Fixed overhead expenditure variance

                        ( Budgeted expenditure - Actual expenditure )

                        ( £50000 - £52000 ) = £ 2000 (A)

Fixed overhead volume variance

                        ( Budgeted output - Actual output ) x FOAR

                        ( 20000hrs. - 22000hrs. ) x £2.50* = £5000 (F)

Fixed overhead absorption rate of £5 is equivalent to £2.50 per hour.

Sales margin price variance

                        ( Standard selling price - Actual price ) x Sales volume

                        ( £30 - £29 ) x 11000 = £11000 (A)

Sales margin quantity variance

                        ( Actual sales - Budgeted sales ) x Standard margin

                        ( 11000 units - 10000 units ) x £3 = £3000 (F)

Activity Based Costing

In recent years there has been criticism of the traditional system of costing for overheads ( Kaplan & Cooper ). Traditional cost systems were designed when:

·      direct costs were the dominant factory costs;

·      overhead costs were relatively small;

·      information processing costs were high;

·      there was a lack of intense global competition;

·      a limited range of products was produced.

Traditional product costing measures accurately volume-related resources eg. direct costs but they fail to measure the way products consume non-volume related activities eg. support services like material handling, set-up costs, inspection costs. Resources are used up when these activities are triggered by production. It is the products which cause these activities to arise and ABC attempts to trace the consumption of these activities by the various products. Products which demand a lot of activities and resources are allocated an appropriate share of the overheads. For example, a new product will probably be low volume initially, requiring a lot of machine set-ups, quality testing etc. so it should bear the overheads it is causing to be created.

Example: Two products A and B are produced ( 5000 units of A and 45000 units of B). Each product requires the same number of machine/direct labour hours.

Number of set-ups:   A = 10       B = 5

The cost of set-ups is £1.2m.

Absorption costing:

        Product A = £120,000 (10% of £1.2m.) / 5000units = £24 per unit

        Product B = £1.08m (90% of £1.2m.) / 45,000 units = £24 per unit

ABC system:

       Product A = £800,000 (10/15 x £1.2m) / 5,000 units = £160 per unit

       Product B = £400,000 (5/15 x £1.2m) / 45,000 units = £8.89 per unit

Since product A, the low volume product is responsible for the greater share of the set-up costs it is only right that it attracts most of this overhead. It is the number of set-ups that is the cost driver. The traditional costing system tends to overcost high volume products and undercost low-volume but complex products.

Definition: Activity based costing (ABC) is concerned with ‘cost attribution to cost units on the basis of benefit received from direct activities eg. ordering, set-up, assuring quality’.

ABC states that activities cause costs and products/cost units consume the activities. It is used by management to determine the most profitable products and to appreciate the cost implications of the operational activities within the business. It gets management to understand what causes costs. The technique uses cost drivers to attribute costs to activities and cost objects. Thus, overheads can be related to the activities which cause them.

ABC divides activities into four categories:

1                    Unit level activities which arise each time a product is manufactured eg. machine power, depreciation of machinery etc.

2                    Transaction level activities which arise each time a transaction happens eg. quality control, inspection costs, set-up costs etc.

3                    Plant level activities which relate to costs arising from the maintenance and operation of the business facilities.

In absorption costing overheads are assigned to cost centres and charged to cost units by usually a volume-based measure such as machine or labour hours whereas ABC uses a two-fold approach by locating costs in cost pools and identifying cost drivers to facilitate assigning costs to cost units. 

In product costing it is relatively easy to charge direct costs to cost units but the problem arises in relation to indirect costs(overheads). Overhead costs(resource costs) such as rent, rates, maintenance costs, cleaning materials etc. which can be identified with a particular cost pool are located there. Other overheads which cannot be identified with a cost pool are apportioned to the cost pools by means of cost drivers which are the main determinants of the cost of activities. These overheads are pre-determined in that they are part of the budgeting process. These cost drivers might include the number of production runs, the number of customer orders received, the number of quality control tests, etc.

Activity cost pool	Activity cost driver
Advertising	The value of sales in each sales area
Quality control	The number of quality tests
Purchasing	The number of purchase orders
Set-up costs	The number of set-ups/production runs
Stores	The number of material requisitions
Despatch	The number of despatch notes

When the overheads are located in the cost pools an average cost per transaction is calculated by dividing the total cost of an activity by the number of transactions performed. This average cost is then used to to charge each product with the amount of service demanded from each activity cost pool. Consequently, products are charged with a fairer share of the overheads they have helped to create. The result is more accurate product costing, better decision-making in respect to the product output mix and product pricing.

Example:

The ABC company produces two products X and Y and the following information is given:

	Product X	Product Y		Total
Production and Sales (units)	25,000	5,000		30,000
	--------	-------		--------
Unit cost (£)
Direct labour	25	20
Direct materials	15	5
Operating data
Machine hours	1	2
Labour rate per hour (£)	1	1
Number of set-ups	4	20
Number of inspections	40	80
Overheads
Production processing			£700,000
Set-up			£120,000
Inspections			£180,000

Required;

Calculate the product costs using (a) Absorption costing (b) ABC.

(a) Assuming the overheads are absorbed on the basis of direct labour hours.

                            Budgeted overheads          £1,000,000

      OAR   =       ---------------------------    =    -------------     =  £2.50 per hour

                             Labour hours                        400,000

All production overheads are located in one cost pool. The unit costs of products X and Y are:

	£	£
	X	Y
Direct labour	15.00	5.00
Direct materials	25.00	20.00
Overhead (2.50 per d.l.h.)	37.50	12.50
	-------	--------
	77.50	37.50
	-------	-------

(b) In ABC three cost pools are identified viz. production processing, set-up and inspection costs. The cost drivers are also identified eg.

Cost Driver	Basis
Production processing	Number of machine hours
Machine set-ups	Number of machine set-ups
Inspections	Number of inspections

The overheads per cost pool and the rate per cost driver are computed.

Production processing costs:

                          Production overhead              £700,000

                         -----------------------------      =    ------------      =   £20 per mach.hr.

                              Machine hours                        35,000

Set-up costs:

            Cost per set-up      Set-up cost             £120,000     

                                           ----------------      =   ------------        =  £5,000 per set-up.

                                          No. of set-ups                 24    

Inspection cost:

            Cost per inspection   Inspection cost 

                                                -------------------   =  £180,000   = £1,500 per                                 

                                              No. of inspections

The final stage of the process is to use the cost driver rates to assign overhead cost to products.

	X	Y
	£	£
Direct labour	15.00	5.00
Direct materials	25.00	20.00
Production overhead (1)	20.00	40.00
Set-up costs (2)	0.80	20.00
Inspection (3)	2.40	24.00
	------	-------
	63.20	109.00
	-------	-------

1                    X =£20 x 1 machine hr. =£20; Y = £20 x 2 machine hours = £40

2                    X = (£5,000 x 4 set-ups)/2,500 units = 80p; Y = (£5,000 x 20 set-ups)/5,000 units = £20

3                    X = (£1,500 x 40 inspections)/ 25,000 units = £2.40; Y = (£1,500 x 80 inspections)/ 5,000 units = £24

 The comparison of the two approaches is given:

	Product X	Product Y
Absorption costing	£77.50	£37.50
ABC	63.20	£109.00

Advantages of ABC

1                     

2                    It recognises the reality in advanced manufacturing environments that overheads are not related to direct labour since the proportion of direct labour costs is small in the total costs of a product. Instead activities cause overheads.

3                    Traditional costing systems tend to understate the overhead cost of a low volume complex product and overstate the overhead cost of a high volume product. ABC tends to allocate overheads to products which consume activities which in turn cause the overheads to arise.

4                    Since ABC produces more accurate product costs, decisions taken by management are better informed eg. pricing decisions.

5                    More accurate product profitability analysis can be produced.

It creates an awareness of the various activities that take place in an organisation and focuses on non-value added activities to ascertain whether they are needed or not.