Cost Centres, Profit Centres, Investment Centres Essay Example for Free

greet Centres, Profit Centres, Investment Centres EssayThe increasing complexity of forthwiths business environment makes it virtually impossible for most firms to be controlled centrally. Decentralisation is a necessary response to this increasing complexity and involves the delegation of decision-making business by senior counselling to sub-ordinates. The structure is such that decision making is dispersed to various units within the organisation, with motorbuss at various levels making key decisions relating to their heart of duty. These heart and souls of organisational natural process are known as responsibility nerves and may be defined as a unit of a firm where an individual manager is held obligated for the units per influenceance. 1The instruction execution of each centre and its manager is footmarkd and controlled through a system of responsibility accounting which is establish on the principles of locating responsibility and tracing be/revenue/ investings e tc. to the individual managers who are primarily responsible. The ingredient of the firm into separately identifiable units of responsibility allows for more accurate metre of managerial performance because local information is more thorough. Overall, in order to obtain an accurate measurement of managerial performance, measures should be based on elements which the manager stop control or significantly influence.There are lead primary(prenominal) types of responsibility centre. A cost centre is the lowest level of responsibility, and performance is measured in terms of the costs incurred by it. Cost centres do non generate revenue and therefore take in no profit objectives, which diametriciates it from profit and investment centres. Managers of cost centres are accountable only for controllable costs and are not responsible for level of activity or long investment decisions. Managerial performance is measured by efficiency of operations in terms of the quantity of inputs employ in producing a given output.The basis of this type of measurement lies in comparing actual inputs to budgeted controllable costs or some predetermined level that represents efficient utilisation. Cost control and efficiency of operations are the main elements of this type of unit. However, costs in general can be difficult to measure, trace and allocate and it can be difficult to differentiate between controllable and uncontrollable costs. This poses a major drawback for the evaluation of cost centres and their management, since cost is its main element of measurement. The focus world mainly on costs, makes this centre some-what weak in terms of evaluation and measurement of managerial performance.Cost centres can be split into two different types standard cost centres and discretionary cost centres. In the former, measurement is exercised by comparing standard cost with actual cost. Variances would be indicative of the efficiency of the centre and therefore its managers pe rformance. Discretionary cost centres are centres where output cannot be measured in financial terms, for example advertising and publicity, RD etc. Control normally takes the form of ensuring that actual cost adheres to budgeted expenditure for each expense category.2 However, a major problem with this type of responsibility centre is the measurement of the effectiveness of expenditure and the determination of the efficiency of the centre itself and its management.A profit centre offers an additional element to the measurement process in that both inputs and outputs are measured in m unrivaledtary terms. The manager of a profit centre has increased autonomy as s/he is responsible for revenue as well as costs hence it is easier to measure the effectiveness and efficiency of managerial performance in financial terms. In this situation, managers are normally free to set sell prices, choose which commercialises to sell in, make product-mix and output decisions and select suppliers.3 A profit centre differs form a cost centre in that its main objective is to maximise profit and the performance of the manager is measured in terms of profit made. Top executives allocate assets to a profit centre, and the manager is responsible for using these assets to make a profit. Each profit centre has a profit target and has the authority to adopt such policies that are necessary to achieve these targets.Profit centre managers are evaluated by comparing actual profit to targeted profit. Profit analysis using profitability ratios or segmented income statements are used as a basis for evaluating managerial performance. The major issue with profit statements is the difficulty in deciding what is controllable or traceable, and in order to treasure the managers performance rather than the economical performance of the unit, measures must be based on controllable profit only. other difficulty arises in allocating revenue and costs to profit centres, as it is unlikely that the profit centre is fatten uply independent. This has prompted many firms to use multiple performance measures such as a balanced scorecard, which measures non-financial as well as financial elements of the unit.The measurement of profit is too compounded by the use of transfer prices and agreeing on its fairness. Transfer prices are allocated to goods transferred from unity unit to another within a firm. The implication of transfer prices is that for the selling unit it will be a source of revenue and for the receiving unit it is an element of cost, and as a result each division may act in its own interests. Transfer pricing therefore has a significant heading when calculating revenues, costs and profits of responsibility centres. The choice of transfer pricing method is important because it affects goal congruence as well as performance measurement. However, it is difficult to determine the correct transfer price, as there are a wide variety of methods available, varying from neg otiation to approaches based on the market or based on cost.The investment centre manager has increased responsibility in comparison to the cost and profit centre managers and as a result there are further options for managerial performance measurement by top management. The investment centre manager has responsibility for revenue and costs, and oerly has the authority to make capital investment decisions. This type of unit represents the highest level of managerial autonomy. An investment centre differs from a profit centre in that investment centre management is evaluated on the basis of the rate of reappearance earned on the assets employed or the residual income earned, while profit centre management is evaluated on the basis of excess revenue over expenses for the period. The manager in charge has the objective of profitability, depending not only on sales but also on profitability of the capital used.Overall, investment centres offer the broadest basis for measurement in the sense that managerial performance is measured not only in terms of profits, but also in terms of assets employed to generate those profits. Performance can be measured using a variety of tools, and this ensures that the drawbacks of one method are overcome by the merits of another. This in turn leads to more accurate results and is one of the main reasons why investment centres are so usual as a pith of managerial performance measurement in large companies.Both the effectiveness and the efficiency of the manager can be assessed by reference to the accounting data available. Investment centres offer many qualities required for good managerial performance measurement. For example, they provide incentives to the unit manager, they can recognise long-term objectives as well as short-term objectives and the increased responsibility means there are more controllable factors for use in performance measurement calculations.Return on investment is a measurement approach in common use in investment centres. This method has the advantage of being elemental and easy to calculate. ROI expresses divisional profit as a percentage of the assets employed in the division.4 It has the further advantage of motivating managers to achieve the best return on investments in order to achieve the associated rewards. ROI provides a return measure that controls the size and is comparable to other measures. It can be used as a common denominator for comparing the returns of similar businesses, such as other divisions within the group or outside competition. It is widely used and most managers understand what the measure reflects.However, some complications arise in the calculation of this method. For example, difficulties regarding the calculation of profit, some of which are described in a higher place. Profit can be defined in a get of ways and this enables the figure to be manipulated. In the case of the figure for investments, the question arises whether this should be inwardn ess assets (gross or depreciated), total run assets or net total assets. The result would differ in each case, but if consistency is maintained throughout the organisation, decisions would remain unaffected.Another difficulty that may arise in sexual relation to this method is that managers may focus on self-interests rather than the overall goal of the organisationand some profitable opportunities may be ignored because s/he fears potential dilution of existing successful endeavours. Furthermore, ROI does not adequately recognise risk. A manager who generates a large ROI result may be investing in riskier assets which may not be consistent with organisational goals. Use of ROI as a managerial performance measure can lead to under or over investment in assets or incorrect asset disposal decisions, in order to achieve the result the manager requires to accomplish his reward.To overcome some of the above difficulties, many firms use residual income to evaluate managerial performance . This method seeks to motivate managers to invest where the expected returns exceed the cost of capital. For the purpose of managerial performance measurement, it compares the controllable contribution of an investment with the targeted rate of return.5 There is a greater possibility that managers will be encouraged to act in the best interests of the company. Another advantage of this method is that it is more flexible because different cost of capital rates can be applied for different levels or risk. Though ROI and RI perish on a similar basis, RI proves better in certain circumstances. For example, if ROI is chosen as the measuring technique, managers may be reluctant to make additional investments in fixed assets as it may bring down the ROI for their centre. RI calculation results would be more accurate in these situations.However, residual income does not overcome the problem of find the jimmy of assets or the figure to be used for profit. If RI is used in a short-term pe rspective, it can over-emphasise short-term performance at the expense of long-term performance. Investment projects with positive net present values can show poor ROI and RI results in early years, leading to rejection of projects by managers. Residual income also experiences problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher RI because of the size of the division rather then superior managerial performance. Another drawback for this method is that it requires an estimate of the cost of capital, a figure which can be difficult to calculate.Economic value added is an extension of the residual income measurement. It measures surplus value created by total investments which include funds provided by banks, shareholders etc. Its key element is the emphasis on after-tax operating profit and the actual annual cost of capital. The latter aspect differentiates it from the RI measure, which uses the m inimum expected rate of return. EVA is a further step towards encouraging centre managers to squeeze on the overall goal of the organisation rather than their own self interests, hence reducing dysfunctional behaviour.The above measures are financial measures. As verbalize previously, it is important also to study non-financial aspects, such as customer satisfaction, quality, internal processes, growth etc. in order to get a more complete picture when measuring managerial performance. The above measures also focus on performance within the investment centre and do not consider the performance relative to overall company objectives.In conclusion, it can be stated that in order to assess managerial performance as opposed to the economic performance of the division, it is vital to make a distinction between the controllable and uncontrollable elements used in the chosen calculations. Each measurement technique is not without limitations, but these difficulties can be overcome by usin g a wide variety of measurement tools and striking the right balance between them. Of the three types of responsibility centre, an investment centre can be considered to yield better results, as it allows for the broadest basis for measurement, making it widely popular as a means of managerial performance measurement.1 C. Drury, Management and Cost Accounting, 6th Ed. P. 6532 C. Drury, Management and Cost Accounting, 6th Ed. P. 6543 C. Drury, Management and Cost Accounting, 6th Ed. P. 654/655 4 C. Drury, Management and Cost Accounting, 6th Ed. P. 8455 IPA Manual, Management Accounting, P 239