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What is Decentralization in Accounting? - Definition & Examples

Instructor: Ryan Morales
Many business organizations are becoming decentralized. In this lesson, you will learn more about decentralization, what responsibility centers are, and how these responsibility centers are evaluated.

In your school and within your local community, you were probably part of formal and informal groups. From experience, you most likely learned that it is easier to manage and organize smaller groups compared to bigger organizations. With fewer people involved, personal connections are often forged, and communication is fostered. Group concerns can be immediately addressed. Basically, it is easier to get things done. This is the reason why many businesses today are open to this idea of decentralization.

What Is Decentralization?

Decentralization is the division of an entire company into smaller, more manageable units. These units achieve some form of autonomy as these are managed by people from their own departments. In a decentralized organization, the lower level managers are given the authority to make operating decisions. The day-to-day operations of these units are left to lower level managers. Such a system frees top management from dealing with minor details. This allows them to focus on important management functions like strategic planning, dealing with major customers and suppliers, making investment and financial decisions, etc.

An advantage of decentralization is better decision-making. This presupposes that lower level managers possess more knowledge and experience as to how their departments operate. They are more acquainted with the common problems faced by their departments. Hence, they make better, more timely decisions. Further, this sense of autonomy empowers lower level managers and motivates them to contribute more to the organization's overall goals.

A potential problem associated with decentralization is management losing control over the company's operations. Lower level managers who are given power may mismanage or abuse their authority.

Decentralization and Responsibility Accounting System

To address this potential problem, a responsibility accounting system is necessary. This system operates under the idea that since lower level managers have the authority to make decisions, they should also be held accountable for the decisions they make. A performance reporting system must be in place. Under the concept of responsibility accounting, units or departments become responsibility centers. Each responsibility center is one of these three types--cost center, profit center and investment center.

Responsibility Centers

Cost Center

A cost center is a unit which incurs costs but does not earn revenues. The manager of this center controls the incurrence of costs. Examples of cost centers are the production department and those departments performing staff function like the human resources department and the accounting department. The human resources department for instance, does not directly generate revenues, but the department incurs costs--personnel costs, overhead, etc. This department performs the important functions of hiring, training, labor law compliance, record keeping, compensation, etc. The same is true for the accounting department and other departments performing support functions.

The production department is also a cost center. This department does not directly generate revenues, but it produces goods and in the process, incurs production costs.

The performance of cost centers is evaluated by comparing their actual costs versus their budgeted costs. The difference between these costs is called a variance. If the actual cost is lower than the budgeted cost, the variance is favorable. This implies that the cost center was able to work well within its budget in pursuit of its goals. If it is the reverse, the variance is unfavorable. In responsibility accounting, all significant variances, whether favorable or unfavorable, should be investigated. This is because significant variances represent deviations from what costs should be. Deviations may reveal issues which management needs to address.

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