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Cost Center, Profit Center, Balance Scorecard
Professor: Ananth Avva, CPA CFA CMA
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Performance measurement against: Strategic business Units, Cost Centers, and profit centers
Role of variable costing and full costing in evaluating profit centers
Balanced scorecard in strategic performance measurement
Learning Objectives
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Performance Measurement & Control
Performance measurement is the process by which managers at all levels gain information about the performance of tasks within the firm and judge that performance against pre-established criteria as set out in budgets, plans, and goals
• Top management, middle management, and operating-level personnel should be evaluated
Management control refers to the evaluation by upper-level managers of the performance of mid-level managers
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Performance Measurement & Control
Operational control means the evaluation of operating-level employees by mid-level managers
Management control focuses on higher-level managers and long-term strategic issues (a broader objective), while operational control focuses on detailed short-term performance
Operational control is a management-by-exception approach while management control is more consistent with the management-by-objectives approach
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Performance Measurement & Control
18-5
Managem
ent ControlO
perational Control
Financial
Management
Operations
Management
Marketing
Management
Plant A Plant BRegion BRegion A
Chief Executive
Employee
1
Employee
2
Employee
3
Employee
4
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Management by Objectives Areas of responsibility are often called strategic business units
(SBUs)
An SBU consists of a well-defined set of controllable operating activities over which the SBU manager is responsible
Motivate managers to exert a high level of effort to achieve the goals set by top management
Provide the right incentive for managers to make decisions consistent with the goals set by top management (that is, to align managers’ efforts with the desired strategic goals)
Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making
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Management by Objectives Areas of responsibility are often called strategic business units
(SBUs)
An SBU consists of a well-defined set of controllable operating activities over which the SBU manager is responsible
Motivate managers to exert a high level of effort to achieve the goals set by top management
Provide the right incentive for managers to make decisions consistent with the goals set by top management (that is, to align managers’ efforts with the desired strategic goals)
Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making
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Principal Agent Model
Outcome of manager’s decision
and effort
Risk
Aversion
Decision
MakingEffort
Receives
Pay
Uncertainty
External Factors
Prepare
Performance
Report
Accounting
Pays Manager
on the
Basis of the
Performance
Report
Top Management
Manager
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Strategic Performance Management
•Cost Centers are a firm’s production or support departments that are charged with the responsibility of providing the best quality product or service at the lowest cost (examples: a plant’s assembly department, data-processing department, and its shipping and receiving department)
•Revenue Centers focus on the selling function and are defined either by product line or by geographic area
•Profit Centers: when an SBU both generates revenues and incurs the major portion of the cost for producing these revenues, it is considered a profit center
• Investment Centers include assets employed by the SBU as well as profits in the performance evaluation
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Strategic Performance Management
The choice of a profit, cost, or revenue center depends on the nature of the production and selling environment in the firm:
• Products that have little need for coordination between the manufacturing and selling functions are good candidates for cost and revenue centers
• For products that require close coordination between these functions, profit centers would be the preferred option
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Cost Centers
Direct manufacturing and manufacturing support departments are often evaluated as cost centers since these managers have significant direct control over costs but little control over revenues or decision-making for investment in facilities
Several strategic issues arise when implementing cost centers:
• Cost shifting occurs when a department replaces its controllable costs with noncontrollable costs (e.g., variable costs to fixed costs)
• Budgetary slack can be good as it reduces risk aversion, but too much slack can result in reduced employee effort
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Implementation
Discretionary-Cost Approach
Costs are mainly fixed, uncontrollableFirms use an input-oriented planning focusOutputs are ill-definedThe focus is on planning
Engineered-Cost Approach
Costs are mainly variable, controllableFirms use an output-oriented evaluation focusOutputs are well-definedThe focus is on evaluation
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G&A Cost Centers
These departments have the same two methods to choose from, but the proper choice may change over time:
–For example, if cost reduction is a key objective, the human resources department might be treated as an engineered-cost center
–Later, it might be changed to a discretionary-cost center to motivate managers to focus on the achievement of long-term goals
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G&A Cost Centers
Total Cost
4,800
3,600
2,400
1,200
Cost Driver
(number of applications)
100 200 300 400
Cost Variance
250
Cost behavior in
administrative
support centers
is often a
step cost
Engineered Cost
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Implementation Considerations
Many firms are choosing to outsource manufacturing, customer service, engineering, and other services
When using a cost center, how should the firm allocate the jointly incurred costs of service departments to the
departments using the service?
An allocation method should be chosen based on its ability to motivate managers, encourage goal congruence, and
provide a basis for fair evaluation of the managers’ performance
Dual allocation is a cost-allocation method that separates fixed and variable costs; variable costs are
directly traced to user departments, and fixed costs are allocated on some logical basis
Indirect costs should be traced to cost Centers using activity-based costing (ABC)
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Revenue Centers
Revenue drivers in manufacturing firms are the factors that affect sales volume,
such as price changes, promotions, discounts, customer service, changes in
product features, delivery dates, and other value-added factors
Revenue drivers in service firms focus on the quality of the service
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Marketing Departments
Marketing departments can be either a revenue or a cost Center:
• The revenue center responsibility stems from the fact that the marketing department manages the revenue-generating process and produces revenue reports for evaluation
• This department can also be a cost center as it incurs two types of costs, order-getting (advertising and promotion) and order-filling (warehousing, packing, and shipping) costs
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Profit Centers
The profit center manager’s goal is to earn profits
Three strategic issues cause firms to choose profit Centers rather than cost or revenue Centers:
• Profit Centers provide the incentive for the desired coordination among marketing, production, and support functions
• Profit Centers motivate service department managers to consider their product as marketable to outside customers
• Profit Centers motivate managers to develop new ways to earn a profit from their products and services
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Strategy Drives Structure
Manufacturing
Plant
Warehouse
Sales
Manufacturing
Plant
Profit
Center
Profit
Center
Sales
Cost Center Revenue Center
Cost Leadership Strategy
Differentiation Strategy
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Contribution Income Statement
• A common form of profit center evaluation is the contribution income statement, which is based on the contribution margin
• Contribution by Profit Center (CPC) measures all costs traceable to, and therefore controllable by, the individual profit center, including traceable fixed costs
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Controllable & NonControllable FC
• Controllable fixed costs are fixed costs that the profit center manager can influence in approximately a year or less, such as advertising, data processing, and management consulting expenses
• Noncontrollable fixed costs are those that are not controllable within a year’s time, such as depreciation and taxes
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Profit Center Measure
Subtracting controllable fixed costs from the contribution margin results in the center’s controllable margin
The contribution margin income statement can also be used to help determine whether a profit center should be dropped or retained
One complication in the preparation of this statement is that some costs that are not traceable at a detailed level are traceable at a higher level
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Contribution Margin IS
The Contribution Income Statement shows the CPC for both Divisions is positive, and when Division B is
partitioned into its three product lines, Products 1 and 2 are shown as profitable, while Product 3 has a CPC loss
of $70.
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Profit Center Measure
Subtracting controllable fixed costs from the contribution margin results in the center’s controllable margin
The contribution margin income statement can also be used to help determine whether a profit center should be dropped or retained
One complication in the preparation of this statement is that some costs that are not traceable at a detailed level are traceable at a higher level
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Performance Measurement and Balance Scorecard
The BSC measures SBU performance in four key perspectives:
• Customer satisfaction• Financial performance• Internal business processes• Learning and innovation
Cost, revenue, and profit Centers focus on the financial dimension
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Performance Measurement and Balance Scorecard
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Performance Measurement and Balance Scorecard
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Performance Measurement and Balance Scorecard
So why doesn’t everyone do this?- Measurement challenges- Alignment challenges- Short-sighted- Doesn’t quiet explain how?
