What it means
Large organisations cannot be managed from the top alone, so they divide into units with their own leaders. A responsibility centre is such a unit, and the type of centre determines which numbers its manager must answer for.
This keeps each manager focused on the results they can affect. There are four main types.
A cost centre is accountable for spending, such as a payroll or call-centre team, a revenue centre for sales, a profit centre for both revenues and costs, and an investment centre for profit relative to the assets it uses. The guiding rule is controllability.
Managers should be held responsible only for items they can influence, otherwise targets feel unfair and behaviour suffers. Costs allocated from head office are normally shown separately for this reason.
Budgets and monthly reports are built around responsibility centres. Each centre gets a budget, and the variance (the gap between actual and budget) is reviewed by its manager and a senior leader.
Large variances are explained in writing. Problems arise when centres trade with each other.
A transfer price (the internal price charged for goods or services between units) must be set carefully, because a poor one can lead a manager to act in their own interest at the expense of the company. Measures also need balance.
A cost centre manager judged only on spending may cut quality, so many firms add service or quality targets next to the financial ones. The mix of measures should match what the centre is meant to achieve.
In practice
Real-world examples
Example 1
A bank's customer-service department is a cost centre with a monthly budget of $400,000. Its manager is measured on staying within budget and on customer satisfaction. Sales results are not part of the target. The head of customer service explains cost trends each month. Surveys check that quality has not fallen.
Example 2
A regional sales team at a software firm is a revenue centre with a quarterly target of $3,000,000. The team does not control product costs. The sales director also tracks the discount given on each deal. Deals with deep discounts need senior sign-off. The sales director rewards it for hitting the target and for winning new accounts.
Example 3
A hotel in a large chain is a profit centre. Its general manager controls room rates, staffing and spending, so she is judged on the hotel's profit of $1,200,000 for the year compared with a budget of $1,100,000. Her bonus is linked to beating that budget.
Think of it
Think of a responsibility centre like a player's position on a football team. The striker focuses on scoring goals, the defender stops the other team, and the goalkeeper guards the net. Everyone has a specific job and is judged on their performance in that exact area.
Formula
Calculation
Return on investment (ROI) = Operating income / Average invested assets
Residual income = Operating income - (Cost of capital x Average invested assets)
Suppose a division earns operating income of $900,000 using average assets of $6,000,000. Its ROI is 900,000 / 6,000,000 = 15%. With a cost of capital of 10%, the capital charge is 0.10 x 6,000,000 = $600,000. Residual income is 900,000 - 600,000 = $300,000, which shows the division creates value above what its capital costs. Many companies prefer this measure because it rewards any project that earns more than the cost of capital.Case study
Seen in the real world
Tidewater Hotels is an illustrative, fictional chain that judged all of its hotel managers on revenue alone. Managers filled rooms with deep discounts, and revenue rose while profit fell.
The finance director redesigned the structure so that each hotel became a profit centre, with managers judged on operating profit against budget. Costs that managers could not influence, such as head-office charges, were reported separately. Each manager also received a short monthly pack showing the hotel's results against budget and against the same month last year.
Within a year, discounting fell and average room rates rose by 6%. In this illustrative story, the chain also began to compare each hotel's return on the assets it used, which highlighted two properties that needed investment or sale. Managers welcomed the clearer targets. Staff turnover among hotel managers also fell in the following year.
Watch out
Common mistakes
- Holding managers responsible for costs or revenue they cannot control, which makes targets feel unfair and encourages excuses.
- Judging a cost centre only on spending, which may lead to cuts in service or quality.
- Using ROI alone for an investment centre, because managers may avoid good projects that lower their percentage return.
Questions
People also ask
What are the four types of responsibility centre?
They are the cost centre, the revenue centre, the profit centre and the investment centre.
How is a responsibility centre different from a cost centre?
A cost centre is one type of responsibility centre, where the manager is accountable for costs only.
Why use residual income instead of ROI?
Residual income rewards any project that earns more than the cost of capital, which avoids the habit of turning down good projects that would lower the percentage return.