We've have just completed the analysis of a very long example that dealt with the preparation of the budget, namely the operating budget and the budget income statement. And we said, that clearly, there are quite a few efforts that are still required to come up with the budgeted balance sheet, with the budgeted statement of cash flow, so all this process is important but it really takes a lot of time, effort, and resources. And now, one of the questions is, why would you bother? Why would we spend so much time and efforts on these budgets? And, in this episode, I will build maybe a small bridge from the budgets to the other very important area of accounting that is called responsibility accounting. Well, you can say, what is it? The idea is very simple and it deals openly with the organizational structure of any company or even of any project. There are always groups of people, units, areas in the organization that are dealing with certain tasks and activities. And therefore, they are accountable for them. So, here, we can see the following path. If we identified these as they are called responsibility centers, then we can trace costs of activities to these centers, and because these centers are filled up with people, we will be able to find a shorter link between costs and people. And then, our idea of control, namely of comparing what is budgeted or planned and what is actually observed. The finding of these sources, of these deviations, that becomes more dealable with, if you will. So that's the whole idea, and that is a very important area in managing investment projects. So, here we can say that, I'll point some of these things out, organizational structure it leads to lines of responsibility. Well, although it sounds kind of generic, but you'll understand what it means. And from here, we need to have coordination. We talked about that before. And that leads us to the idea of a responsibility center. That is, like I said, a unit, a part, a group of people that are accountable for a certain activity. And therefore, we can say that, if this is the case, then responsibility accounting, I'll use RA here, this is a system that allows to measure and compare. And measure what? Measure plans and compare with results. So here, I will put in blue, I'll put budgets, and here, results. So now, you can see clearly that responsibility accounting is a system that allows both controlling what's going on, and at the same time, that is the basis for the feedback process. And, as we'll see in just a minute, the structure of these responsibility centers, that allows us to find, like I said, a shorter link, a more direct cause and effect thing. Remember, when we talked about indirect costs, we said that in cost pools, the important idea is to make sure that there is a traceable cause and effect link. Now this is, in reality, achieved by the proper identifying these responsibility centers and by the organization of the system of responsibility accounting. Let's see. Here I'll put some types of responsibility centers. And, there are basically four major types. First of all, this is a cost center. Then, I'll put them all. And then revenue center, profit center. You can see that profit center is a combination of the first two to some extent. And then finally, the investment center. Now, to give you an idea in a consistent industry for example, let's say we analyze the hotel industry. Then, the cost center maybe the fixed and maintenance department at a hotel. Then, when we come to revenue center, that's the sales department, when we deal with the combination of both, we come at the profit center, and here, this is a responsible probably hotel manager. And, when we go even further up to the investment center, that's maybe the regional chain of hotels where the manager of this regional chain decides what we can do, and that may be closing down some of the hotels and then building some new ones and so on and so forth. Well, I made this mistake when I said they are indeed. That is because, for example, if we take a financial institution, then, the classic cost center would be the research department. Well, it's close to me because in my previous career, I once was the director of research at an investment company. So, I remember that I was a cost center. That would mean that, whatever the results of the company would be, then clearly, the company management would always be trying to limit the resources they would use for a department, all these salaries, bonuses, and then some coverage of technical, and other costs. Now, the story here is, that at any center, there is a person that sort of heads the center, and the team that is associated with the center. So now we can see that responsibility accounting, it deals much more directly. With people. Well, you can say this is kind of a thing that I've been repeating and maybe that already seems boring to many of you but let me give you an example how this works. Supposedly, there is a factory and then the people from the sales department, they rush into the production scheduling department saying, "Well, we have a need to organize a rush production run because we have a really important order for this customer." Then the production people say, "Well, we can do that but that will lead to significant costs because we have to readjust our processes, then we have to put this order ahead of others that have already been planned and so on and so forth." Then the salespeople say, "Well, does that mean that you would like to take responsibility for losing this customer if we fail to deliver on this order?" That's a classic conflict. Now, before these salespeople came, everything was kind of smooth. On the other hand, if the production people say, "Well, no way. We will not do that so this client should be included in this line of orders and when his turn comes, then will be able to deliver all the necessary products and services respect to this order." That may not be the thing that the customer wants. Now, how can we solve this problem? Now one of the ideas is very simple and again here we say, "Well, you guys at sales, you sort of created this problem." Why wouldn't we do the following, we will say, "No questions asked. We will take this order right away and we'll deliver that on time but the additional costs that we will positively incur, they will be charged to the sales department." Now this way, at least part of this conflict has been resolved. Well, that does not prevent us from some readjustments, some extra work or so but at least, the people in production they know that because they were not sort of the originators of this rushed production run, now some kind of fairness has been achieved. That is a very simplistic example but you don't have to be a whiz to realize that we face them every day, regardless of what we do in our companies if we work, or that happens even in the studying process. Another very important thing here is that worried only for the need to sort of point at someone saying that you are responsible. Well, that's one of the goals of responsibility accounting and it doesn't seem to be very positive. It's sort of a potential punishment or potential holding someone liable for having committed something. But here, we can say that responsibility accounting like I said, allows to trace costs to the individual who is in charge or to the activity. Again, that sounds very scary. We trace these costs and then we say you are responsible. But the important thing here is that if we remove this veil of total control, we can say that there is something positive in that too. Now, before quoting what is really positive here, I would like to mention one more thing. This is responsibility versus controllability. Now, the story here is that we know that budgets and responsible accounting it's all about control. But control and controllability, these are not synonyms because oftentimes, costs are not perfectly controllable because basically, controllability that means sort of who is responsible and when because controllability occurs only over a certain pre-specified period of time. If we pushed for controllability and if we say that we have to really fix labels to every center and ideally to every person that this or that person is be held liable for having committed any action. We always know who is the person in charge and therefore this person doesn't have to be made a scapegoat, they will just be held liable. And that like I said is sort of negatively colored and scary but the story is, that if we do not push for this controllability and we will focus on responsibility because responsibility is closely linked to another thing and I'll put here. This is information and behavior. We can say that the responsibility accounting deals with who is best informed about this product, this cost of this activity. Who can actually explain what's going on when we see some uncontrollable factors? This way, we remove this veil of potential punishment or this Damocles sword, over the heads of these poor managers or people at large at a company or a project. Instead, we say that if someone knows better or knows best, this is the person. That is what we mean by tracing costs. Here, the key story is like I said, knowledge and this is who is best informed. And if we organize the system this way then we can provide real incentives and real motivation for the people because if indeed we find out who is best informed, then we'll be able to come up with much better budgets based on this information and therefore our potential deviations would not be as drastic. Wrapping up this idea of responsibility accounting, we can see that although this is sort of a clearly the managerial focus but for us the students of value. That is also, although indirectly but important area because if responsibility accounting is organized at the level of a project or the company, then indeed there is a higher probability that some of the plans will be converted into actual results and the forecasts will be not just wishful thinking numbers but actually observed actual numbers when they finally occur. That shows us why responsibility accounting is important to keep in mind when we analyze investment projects and when we evaluate companies.
