An investment center includes profit and the efficient use of assets. The traditional performance reports only measure revenue and expenses. We need a way work assets into the evaluation.
Typically when we talk about the efficient use of assets whether those assets are buildings, machinery, furniture, or stocks, we look at how much income those assets are generating. With stocks, we look at the gain on the investment and any dividends the stock pays. With company assets, like buildings and equipment, the income generated is company profit. The company uses those assets to produce products and sell those products.
Investment center performance evaluation uses return on investment (ROI) to evaluate performance.
Return on Investment = Operating Income / Total Assets
This formula will give you a percentage return on investment similar to what you would see when evaluating stocks.
Return on investment can also be calculated by using two other ratios: profit margin and asset turnover.
Profit margin is the percentage of each sales dollars that end up as profit. The higher the percentage, the better the results.
Profit Margin = Operating Income / Sales
Asset turnover tells us how efficiently the company uses assets to generate sales. The company wants to maximize the assets it has to generate as much revenue as it can. These means that the company does not want to have idle equipment or assets that are not in use. This is not a percentage, but the higher the number is the better the results.
Asset Turnover = Sales / Total Assets
Profit margin multiplied by turnover will also give you return on investment.
ROI = Profit Margin X Asset Turnover
This works because sales in the denominator of the profit margin formula cancel out sales in the numerator of the asset turnover formula.
ROI = Operating Income /
Sales X Sales / Total Assets = Operating Income / Total Assets
Investment centers use return on investment to evaluate managers because return on investment measures the efficient use of assets. A higher return on investment means higher efficiency in asset use.
Performance evaluation requires managers to have a benchmark to use as a guide for future periods. This benchmark is communicated to managers via a budget for their responsibility center. At the end of the year, managers are evaluated based on the actual figures generated by the responsibility center. Remember that responsibility managers are only responsible for certain numbers and therefore only those numbers should appear on the performance evaluation report. Let’s look at some sample performance evaluation reports for the three types of centers that use them.
Cost Center Performance Evaluation Reports
A cost center performance evaluation report only contains expenses for the segment of the company that the manager is responsible for. Here is an example of a performance evaluation report for the human resources department of a large company.
This performance report contains the expenses for the human resources department of a company. The expenses are listed with both the budget and actual figures. The variance column is the absolute value (no negative numbers) of the difference between the budget figure and the actual figure. Because the absolute values are used, there must be a way to determine if the variance is good or bad. Next to each variance, you need to indicate if the difference is a favorable or unfavorable. For expenses, a favorable variance is one where actual cost is less than budgeted. The department saved money, which is a good thing. Unfavorable variances occur when the company spent more than planned.
When determining if a variance is favorable or unfavorable, look to see if the actual amount is larger or smaller than the budget amount. For salaries, actual is less than budget. Because this is an expense, actual less than budget is favorable.
The percent variance is calculated by dividing the variance by the budgeted amount.
% Variance = Variance / Budget
The percent variance gives the reader perspective. Salaries have a $500 variance but it is only 0.14% of the budget and therefore a very small percentage of the total budget. Office supplies on the other hand are off by $250, but that is a 25% variance. Use percentages to determine which line items are important to investigate further. Typically, a variance of more than 5% should be investigated.
Revenue Center Performance Reports
A revenue center performance report looks very similar to a cost center performance report.
Notice that the only difference is the name at the top of the report and that the word “expense” has been replaced with “product”. Make sure to look at each report carefully to determine if you are looking at a cost center report or a revenue center report.
The only difference with a revenue center performance report is the determination of favorable or unfavorable variances. Use the same methodology used in the cost center report. Look to see if the actual amount is greater or less than the budgeted amount. For the Standard Model, actual is more than budget. Here we are discussing revenue. Is higher revenue good or bad? Higher revenue is good, so the $90,000 variance is favorable. The Deluxe Model has sales $20,000 lower than budgeted, which is bad and therefore unfavorable.
A company should not just investigate unfavorable variances. The Executive Model’s sales were 10% higher than budgeted. The national sales director might want to know how the Midwest Region was able to increase sales in order to help boost sales in other regions of the country. Favorable variances are just as important as unfavorable variances.
Profit Center Performance Reports
Because a profit center is evaluated based on revenue and expenses, the performance report will be based on a segment income statement.
This report looks very similar to the cost center and revenue center performance reports. The only difference is the inclusion of revenue and expenses on the report. Pay careful attention to the accounts when determining if the variance is favorable or unfavorable. Remember the rules for revenue and expenses. Ask yourself if the variance is a good thing or a bad thing. For contribution margin and profit (segment margin), when actual is higher than budget that is a positive. The higher your contribution margin and profit, the better. That would be a favorable variance. When contribution margin and profit are less than budgeted, it is unfavorable.
The hardest part of the performance evaluation reports is determining if a variance is favorable or unfavorable. Ask yourself one question: Is this change a good thing or a bad thing? That will make the process so much easier.
As managers get more decision making responsibilities because of decentralized management, organizations must find ways to evaluate those managers in an effective way. The first step in the process is assigning responsibility centers to each manager.
A responsibility center is a segment of the company for which a manager is responsible. This allows the company to gather quantitative information regarding the segment in order to assess the performance of the manager. There are four types of responsibility centers:
- Cost Center – The majority of managers are responsible for cost centers. A cost center is a segment where the manager is only responsible for managing costs. Examples of cost centers include human resource departments and production departments. These departments are not concerned with revenue generation. Therefore, managers are evaluated on their ability to manage costs. When attempting to determine if a segment is a cost center, determine if revenue is a factor. If revenue is not a responsibility of the manager of the department, the department is a cost center.
- Revenue Center – While revenue is a major factor for most businesses, revenue centers are actually the smallest portion of responsibility centers. Typically, revenue centers are sales territories and sales departments. These managers are evaluated based off their ability to generate revenue. This segment is rare because most managers that are generating revenue are also responsible for managing the costs of generating that revenue.
- Profit Center – These responsibility centers are also quite common. A profit center manager is responsible for generating revenue but also managing costs to increase profitability. These managers include retail managers, like Target or Wal-Mart store managers. These managers must maximize profitability in their stores, but major decisions about asset management (like renovations and improvements) are outside their scope of responsibility.
- Investment Center – While we spend a lot of time discussing profit, asset management is just as important. If assets are not managed efficiently to maximize the profit that can be made with those assets, the company runs the risk of hurting cash flow and future profitability. Managers in an investment center are responsible for asset management and profit maximization. These managers have the ability to approve the construction of new factories, stores, and the purchase of major equipment. Investment center managers include CEO’s of major companies and small business owner-managers. If asset management is involved, the segment is an investment center.