When I was a kid, my parents would buy me clothes that were probably two sizes too big. They’d say, “You’ll grow into it.”
Business owners need to set themselves up to grow. Businesses need to scale, or create structures that promote smooth growth. Responsibility accounting is just one mechanism to prepare for building a larger business.
Overview: What is responsibility accounting?
Responsibility accounting creates a structure that ties an employee to the performance of every business function.
The structure separates every business function or department -- e.g., sales, accounting, inventory management — into one of four categories, called responsibility centers, based on whether it has control over business revenues, costs, investments, or a combination of these.
Responsibility centers are created until every revenue and expense on your profit and loss statement has been assigned to an employee.
The end goal is that employees are only measured against results they can control, and each business function has a manager who can answer for its performance.
You’re also slicing your business up into smaller bits, which helps assess your business’s health through ratio analysis. Categorizing your business functions splits up your business’s master budget in a new way.
Though responsibility accounting is most commonly used in global organizations with several departments, you can adapt this structure to a small business with a handful of employees. We’ll show you how.
Benefits of responsibility accounting
A business that implements responsibility accounting develops clear expectations for its employees, can provide new insights into profitability, and prepares itself for growth.
Even if you can count your employees on your own 10 fingers, there’s still value in using responsibility accounting. On small teams, each employee has a significant role to play in the success of your company.
1. It establishes clear expectations
If nothing else, bringing a responsibility accounting system to your business adds a level of structure to your company and clears up expectations for each employee.
To employ a responsibility accounting management approach, think about each employee’s role in the company by listing his or her duties. Does the employee have control over revenue, costs, or both? You’ve correctly implemented responsibility accounting when you have at least one person responsible for each revenue and expense account in the company’s chart of accounts.
With their duties and the extent of their control in mind, you can build and share the metrics that you’ll use to evaluate their performance periodically. A business owner who measures employee performance with a standardized scale is managing by objectives, a common management style compatible with responsibility accounting.
Responsibility accounting also allows management by exception. Under this approach, a business owner pays special attention to areas of the business that are underperforming or overperforming.
In other words, a business owner should know whom to call in for an explanation when the company misses its financial projections.
2. It provides new insights
Responsibility centers make you look at your business in a new way. You’re bound to learn something new about its profitability. By creating artificial silos within your business, you glean new information about the performance of specific aspects of your business.
Your small business that sells shoes might seem like one business. But you can split it into several businesses, or profit centers, based on inventory:
- Women’s shoes
- Men’s shoes
- Dress shoes
- Casual shoes
If there’s only one manager responsible for these goods, you can still benefit from thinking of your business as separate departments. You can maximize profitability by gleaning what types of inventory are earning the most.
Unlock the potential of your accounting software’s powerful analytical tools by creating new responsibility centers.
3. It’s a must for a small business with big aspirations
Large organizations have too much going on for the C-suite to follow each employee closely. Responsibility accounting cuts down on executives’ oversight time and keeps their eyes on the business’s long-term strategy.
Growing businesses benefit from standardizing as many operations as possible, including employee evaluations. As your business adds employees, it becomes increasingly challenging to track how each employee is performing unless they’re held to a standard.
Since managers exist at all levels of an organization, responsibility centers come in all sizes and can be nested inside each other. Responsibility accounting creates the structure necessary for scaling.
Types of responsibility centers
Responsibility centers help upper management in large organizations create a slate of metrics against which to evaluate managers in different areas of the business.
There are four responsibility center types: profit center, cost center, revenue center, and investment center. Small business owners might have a hard time deciding how to split their businesses into responsibility centers, but remember: You can have a center with just one employee.
Let’s implement a responsibility accounting system at Kimberly’s Pizza Palace, which employs two pizzaiolos (the term for a person who makes pizzas) and two cashiers.
Type 1: Profit center
A profit center operates as a mini business inside a larger company. The manager has control over both costs and revenues.
When you walk into a department store, you’re looking at several profit centers under the department store’s umbrella. The women’s clothing, men’s shoes, and home furnishings sections are profit centers with their own business budgets, expenses, and revenues.
If you can’t decide whether a certain area of your business is a profit center, ask whether the department can fill out its own profit and loss statement.
Does the department bring in money through the sale of products and services? Does the department manager make cost decisions by hiring employees, offering discounts, or deciding what goods to sell? If the answer to both questions is yes, you’re looking at a profit center.
Kimberly’s Pizza Palace appears to be a simple business that can’t be redefined into responsibility centers. But we can create two separate profit centers with the pizzaiolos.
One pizza maker gets paid more than the second because he has more experience. The second pizzaiolo makes less and specializes in making meat-lovers pizzas, which is the most expensive pizza at Kimberly’s.
You can create a responsibility report for each pizzaiolo. Each report will look like an income statement that breaks down business profits by pizzaiolo.
You might discover that a significant portion of your revenue is thanks to the second pizzaiolo, because he makes a mean meat-lovers pizza. From there, you can decide how many hours each pizzaiolo works and what to pay them.
Type 2: Revenue center
A revenue center’s sole task is to bring in money through the sale of products and services. Managers have no responsibility for business expenses.
The classic example of a revenue center is the selling department of a company, where the manager might be evaluated solely on the department’s sales record.
But accountants argue whether revenue centers exist only in theory. Revenue centers should be concerned purely with sales. But it’s hard to call anything a revenue center when there are no parts of a business where you don’t have to spend any money to make some back.
Some say an apartment building’s leasing office is a revenue center, since it exists only to generate revenue through rent-paying tenants. But a leasing manager’s responsibilities extend past the number of leases signed. A leasing office incurs many costs, including the salaries and commissions for leasing agents.
Since it’s improbable that the leasing manager has no role in some part of the hiring process, you can’t separate the leasing manager’s sales responsibilities from the costs he or she manages.
You might be inclined to think of the Kimberly’s Pizza Palace cashiers as part of a revenue center, but they’re not.
While they are essential to the cash collections of the business, cashiers do not actively sell the pizza. A cashier’s performance evaluation should not be tied to the business’s sales; instead, it should be related to their competencies in counting cash, giving accurate change, and moving the line along.
Type 3: Cost center
Nobody argues the existence of cost centers. They’re the parts of a business that don’t seek to earn revenue. Instead, they support operations: Think of your accounting, legal, and human resources departments. Though they’re not revenue-generating, cost centers are essential to keeping the business moving.
Many parts of department stores represent cost centers. A customer service department doesn’t earn the business money, but it’s needed to keep shoppers happy. Complimentary tailoring services support clothes sales in multiple departments, but you can’t trace revenue to the tailoring department.
A small business should consider its bookkeepers, maintenance staff, and customer service employees as cost centers. They’re essential to your business, but their performance evaluations should have nothing to do with the business’s sales.
The cashiers at Kimberly’s Pizza Palace can be considered part of a cost center. They’re essential to the business, but they cannot drive revenue. They are a cost to the pizza shop.
Type 4: Investment center
Investment centers are concerned with the effect that investments have on business revenues and expenses. Investment centers manage accounts receivable, or the money a business is owed from the sale of goods and services.
Business investments include the purchase of assets your business keeps for more than one year, such as machinery, cars, buildings, and land. These purchases can significantly affect your business, and those responsible for big purchasing decisions should be evaluated on the asset’s impact on the business’s bottom line.
For example, Kimberly, the owner of Kimberly’s Pizza Palace, might consider buying new pizza ovens that cook pizza in less time. The current ovens operate more slowly and are at risk of breaking in the next few years.
Kimberly’s self-evaluation should include an analysis of the new ovens’ effect on business. Sales might increase after word gets around that pickup times have decreased; sales could also stay the same because nobody cared about the longer pickup times.
Assess your business from a new angle
Paramount to a business’s success is accounting organization. After you master the bookkeeping basics, consider how you can enhance your business’s structure with a responsibility accounting system.