Performance evaluation criteria
An income statement measures the overall performance of a business entity. However, managers also need accounting information measuring the performance of each center within the business organization. This information assists managers in the following tasks
- Planning and allocating resources. Management needs to know how well various sections of the business are performing in order to set future performance goals and to allocate resources to those responsibility centers offering the greatest profit potential.
If one product line is more profitable than another, for example, the company’s over all profitability may increase by allocating more production capacity to the more profitable product.
- Controlling operations. One use of responsibility center data is to identify those portions of the business that are performing inefficiently or below expectations. When. revenue lags, or costs become excessive, center information helps to focus management’s attention on those areas responsible for the poor performance. If a part of the business is unprofitable, perhaps it should be discontinued.
- Evaluating the performance of center managers. As each center is an area of management responsibility the performance of the center provides one basis for evaluating the skills of the center manager.
Cost Centers Profit Centers and Investment Centers
Business responsibility centers are usually classified as cost centers, profit centers, or investment centers. To illustrate, assume that Health corp owns and manages a 700-bed hospital and seven clinics located throughout the greater Chicago area. Each clinic is
equipped with its own medical lab and x-ray facilities
A cost center is a business section that incurs costs (or expenses) but docs not directly generate revenue.’ Health corp views its administrative departments accounting, finance, data processing, and legal services-as cost centers. In addition, it also views laundry, maintenance, and janitorial functions as cost centers. Each cost center provides services to other Health corp centers. However, none sells goods or services directly to Health corp’s patients.
Cost centers are evaluated primarily on (I) their ability to control ‘Costs and (2) the quantity and the quality of the services that they provide. Because cost centers do not directly generate revenue, Income statements are not prepared for them: However, accounting
systems must accumulate separately the cost” incurred by each cost center.
In some cases, costs serve as an ‘active basis for evaluating the performance of a cost center. For example, Health corp’s laundry service can be evaluated primarily on the basis of its cost per patient-day. In evaluating the performance of its main tenancq department, the focus is less on costs and more on a subjective assessment of whether medical equipment is properly maintained
A profit center is a part of a ‘business that generates both revenue and costs.: This chapter’s opening story identified 250 profit centers at Siemens AG. At Health corp, the hospital and each of its seven clinics are primary profit centers. Within the hospital, the pharmacy, radiology, emergency room, and food services also are viewed as profit centers.’ Likewise, in each clinic the medical lab and x-ray department are considered profit centers. Examples of profit centers in other types of organizations might include product lines, sales territories, retail outlets, and specific sales departments within each retail outlet
A some, for example, each of the labs in Healthcorp’s seven clinics is profitable. On a square-loot basis, however, the x-ray departments are far more profitable. In this case. management might consider closing some labs and using the space for additional x-ray facilities. (If labs are closed, lab work could be provided by independent medical laboratories.)