Responsibility Margin Accounting Help

We have mentioned that contribution margin provides an excellent tool for evaluating “the effects ‘of short-run decisions on profitability. Such decisions typically do not involve changes in a company’s fixed costs. Unlike short-run decisions, long-run decisions often” have fixed cost implications. Thus the responsibility margin is considered a more useful longer-run measure of profitability than the contribution margin because it takes into consideration changes in fixed costs traceable to a particular business center. Examples of such long-run decisions include whether to expandcurrent capacity, to add anew profit center, or to eliminate a profit center that is performing poorly.

To illustrate how the responsibility margin of a profit center can be used to measure performance. we will examine NuTech’s Retail and Mail-Order divisions. The company’s income statement for these two divisions is shown on the following page, (The format is identical to that shown on page 897, except for the inclusion of component percentages which accompany the dollar amounts

BuslneS8 Centers

BuslneS8 Centers

Which of NuTech’s two divisions is most profitable? The answer depends on whether you are making short-run decisions, in which fixed costs do not change, or long-run decisions, in which changes to fixed costs become important factors

First, let us consider a short-run decision. Assume that NuTech’s management has recently budgeted $5,000 for a radio advertising campaign. However, it is not certain whether to use the $5,000 to promote its Retail Division or its Mail-Order Division.

Now let us take a longer-run view. Assume that NuTech has decided to downsize and continue operating only one of its divisions. Given that current revenue and cost relationships are expected to remain’ relatively stable over time, which division would you recommend that ‘NuTech continue to operate? The answer is the Retail Division

In summary, when making short-run decisions that do not affect fixed costs, managers should attempt to generate the greatest contribution margin for the additional costs incurred. This’ usually means emphasizing those centers with the highest contribution margin ratios. When making long-run decisions, however, managers must consider fixed cost implications. This requires a shift in focus to responsibility margins and responsibility margin ratios.

When Is a Responsibility Center “Unprofitable”?

In deciding whether a specific profit center is “unprofitable,” numerous factors must be considered. Responsibility margin, however, is a good starting point. As we’ve seen, this margin indicates the ‘extent to which a profit center earns an adequate contribution margin to cover its traceable fixed costs.

To illustrate, consider the following income statement prepared by NuTcch’s 42no Street store

Profit Centers

Profit Centers

According to these data, discontinuing the Repairs Department would eliminate $20,000 in revenue and $22,000 in costs ($8,000 in variable costs and $14,000 in traceable fixed costs). Thus closing this department might well increase the profitability of the store by $2,OOO-its negative margin

Evaluating Responsibility Center Managers

Some fixed costs traceable to a center are simply beyond the manager’s immediate control. If a center is saddled with high costs that are beyond the manager’s control, the center’s reported performance may not be indicative of its manager’s individual performance. This can be an extremely sensitive issue, especially when a manager’s compensation or bonus is affected.

To illustrate, assume that NuTech’s 42nd Street store has been open since 1956. whereas its Baker Street store has been in operation for only three years. Consequently. the depreciation and property taxes applicable to the Baker Street store far exceed those incurred at the 42nd Street store. If the bonus ‘paid to the manager of the Baker Street store is based solely on the store’s responsibility margin, this manager will be unjustly.  penalized for serving at the newer location.

Subdividing traceable costs in this manner draws a distinction between the performance of a center manager and the profitability of a center us a long-term investment. The performance margin includes only the revenue and costs under the manager’s direct control, making it u .eful in evaluating the manager’s abillty to control costs. The responsibility margin, however, is used for measuring and evuluaung the long-term profitability of the center viewed as a whole.

case in point

case in point

Arguments Against Allocating Common Fixed Costs to Business Centers

We have mentioned that some companies follow u policy of allocating common fixed costs among the business centers benefiting from those costs. The bases used for allocating common costs are necessarily arbitrary, such as relative sales volume or square feet of floor space .occupied by the center. In a responsibility income statement, responsibility margin less common fixed costs is called “operating income.” We do not recommend this practice, for several reasons:

I. Common fixed costs often ‘would II(){ change even (f (/ business center were eliminated. Therefore, an allocation of these costs only distorts the amount contributed by ‘each center to the income of the company

2. Common fixed costs are not under the direct control of the center’s managers. Therefore, allocating these costs to the center does not assist in evaluating the performance of managers.

3. Allocation of common fixed costs may imply changes in profitability that are un related to the center’s performance.

Transfer price for Multinational Companies

Setting appropriate transfer. prices becomes much more complicated if parts of a business are located in different countries. If goods are shipped across international borders, the transfer price may be affected by taxes, duties and tariffs, and international .Tn addition. the market value of the goods may be quite different in the country in which they are manufactured and in the country to which they are shipped.

Cash Effects

Inter company transfer price entries (Ire eliminated when cash flow statements are constructed. Transfer prices are not revenue for a firm and they do not generate cash flows. However, international transfer prices between a firm’s subsidiaries in two different countries with ,Aferent tax rates can have cash flow impacts for the overall firm.

Posted on November 24, 2015 in Responsibility Accounting and Performance Evaluation

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