In expense centers, inputs or expenses are measured in monetary terms whereas the outputs are not measured in monetary terms. There are two types of expense centers – engineered expense centers and discretionary expense centers.
- Engineered expense centers: In these centers, inputs or expenses are measured in monetary terms and outputs are measured in physical terms. These centers are usually found in the manufacturing units that use a standard cost system. There are certain responsibility centers within administrative and support departments that actually are engineered expense centers. In these centers, the cost of the product is determined by multiplying the output of each unit with its standard cost. Its efficiency is measured by comparing the actual cost with the standard cost.
- Discretionary expense centers: In discretionary expense centers, the output cannot be measured in monetary terms. Discretionary expense centers include administrative and support units like legal, accounting, industrial and public relations units. Here, the efficiency is not the difference between budgeted and actual expense, but the difference between the budgeted input and actual input. In discretionary expense centers the management decides on certain policies that should govern the company’s operation. These relate to the amount of money that should be spent on R&D, financial planning, public relations, etc. The decisions related to such activities depend on the way a company operates.
Control Characteristics for Expense Centers
The management control systems for expense centers are discussed, taking into consideration factors like budget preparation, cost variability, financial control and measurement of performance.
- Budget preparation: The decisions regarding the budget of expenses for a discretionary expense center is different from that for an engineered expense center. In engineered expense centers, the costs are determined by the management, taking into view the operating budget required to perform the task effectively in the future. However, in a discretionary expense center, the principal task is to decide on the magnitude of the job that has to be performed. These tasks are of two types-continuing and special. Continuing tasks take place year after year (like financial statements) while special tasks are one-time tasks, for example, developing a profit budgeting system for a newly acquired division. Management by objectives is a useful technique in preparing budgets for a discretionary expense center. Management by objectives is a technique where the objectives of performance are jointly determined by subordinates and their superiors. The progress towards these objectives is periodically reviewed and the rewards are allocated on the basis of performance. Another method used to understand the appropriate level of spending in a discretionary expense center is sensitivity analysis. According to this technique, the budget has a section which explains the activities that can be undertaken if the budget is increased. Sensitivity analysis is mostly not taken by companies as they think that it is important for a manager to prepare the possible budget for accomplishing activities that should be undertaken.
- Cost variability: There are two types of cost involved in engineered expense centers and discretionary expense centers respectively – engineered costs and discretionary costs. Engineered costs are costs that can be estimated to a reasonable extent by the management. Examples are direct labor and direct material. Discretionary costs, on the other hand, are costs that cannot be estimated by the management. The costs, in a discretionary expense center, tend to vary from one year to another according to the volume. However, these are not influenced by short-term fluctuations in volume within a year. In engineered expense centers, costs vary with short-term fluctuations in volumes.
- Financial control: The financial control in a discretionary expense center is different from that in an engineered expense center. Here, the operating costs are minimized by setting a standard for the costs and comparing the actual costs with this standard. In discretionary expense centers, costs are controlled by determining the tasks that have to be undertaken and the amount of effort that is required for each task. Financial control is, hence, determined at the planning stage.
- Measurement of performance: The financial performance report of a discretionary expense center does not help in evaluating the efficiency of the manager, whereas in engineered expense centers the financial report helps in evaluating the efficiency of the manager. If the two centers are not properly distinguished, the management may consider the performance report of a discretionary center as an indication of its efficiency.