Performance Evaluation Lecture Notes

Performance Evaluation Lecture Notes Learning Objectives 1. How are profit centers evaluated? 2. How are revenue centers evaluated? 3. How are cost centers evaluated? 4. How are investment centers evaluated? Profit Center Evaluation What do Profit Centers decide? Input mix, sales m...

Performance Evaluation Lecture Notes Learning Objectives 1. How are profit centers evaluated? 2. How are revenue centers evaluated? 3. How are cost centers evaluated? 4. How are investment centers evaluated? Profit Center Evaluation What do Profit Centers decide? Input mix, sales mix, selling prices, … but not how much to invest or disinvest. What do Profit Centers control? Both revenues and costs that are controlled by revenue centers and cost centers, respectively, under the profit center. Performance Measure Profit Variance = Actual Profits vs Budgeted Profits If actual profits > budgeted profits, then the profit variance is labelled as Favorable (F) and if If actual profits < budgeted profits, then the profit variance is labelled as Unfavorable (U). Profit = Revenues – Costs So evaluation of a profit center boils down to evaluation of the revenue centers and cost centers under the profit center. 1 Revenue Center Evaluation What do Revenue Centers decide? Who to sell, selling discounts, sometimes selling prices too. They have a limited cost budget under their control for travel and promotion. What do Revenue Centers control? Primarily revenues and through revenues something called Contribution Margin where Contribution Margin = Revenues – Variable Costs Contribution Margin per unit = Selling Price – Variable Costs per unit Variable Costs are costs that change proportionately with volume of product produced or sold as opposed to Fixed Costs that do not change with volume. Performance Measure Contribution Margin Variance attributable to the revenue center holds variable cost per unit at budgeted amount and determines to what extent deviation in selling price (actual vs budgeted) and deviation in sales volume (actual vs budgeted) contributed to deviation in contribution margin (actual vs budgeted). Therefore, Contribution Margin Variance can be decomposed into selling price variance and sales volume variance. Selling Price Variance is the deviation in contribution margin arising from difference in selling price (budget vs actual) and is computed as |Actual Selling Price vs Budgeted Selling Price| * Actual Sales Volume If the actual selling price > budgeted selling price, then the selling price variance is labelled as Favorable (F). If the actual selling price < budgeted selling price, then the selling price variance is labelled as Unfavorable (U). Sales Volume Variance is the deviation in contribution margin arising from difference in sales volume (budget vs actual) and is computed as |Actual Sales Volume vs Budgeted Sales Volume| * Budgeted Contribution Margin per unit If the actual sales volume > budgeted sales volume, then the sales volume variance is labelled as Favorable (F). If the actual sales volume < budgeted sales volume, then the sales volume variance is labelled as Unfavorable (U). The Contribution Margin Variance is the sum of the above two variances i.e. Contribution Margin Variance = Selling Price Variance + Sales Volume Variance The contribution variance can be Favorable (F) or Unfavorable (U). 2 Cost Center Evaluation Two types of Cost Centers: Engineered Cost Center and Discretionary Cost Center Engineered Cost Center Engineered cost centers have a clear relationship between inputs and output e.g. a factory. Performance Measure is Total Cost Variance = Actual Costs vs Flexible Budget for Actual Output Produced [not original budgeted cost that was for budgeted output] Flexible Budget for Actual Output Produced = [Budgeted Variable Cost per unit * Actual Output] + Budgeted Fixed Costs If Actual Costs < Flexible Budget for Actual Output Produced, then the Total Cost Variance is Favorable (F). If Actual Costs > Flexible Budget for Actual Output Produced, then the Total Cost Variance is Favorable (U) The Total Cost Variance can be broken down by each cost item or component and further decomposed. Will learn about it in variance analysis of cost centers. Quality, response time and meeting output targets are important for engineered cost centers, but these have to be met by producing cost efficiently. Further, Profit Variance = Contribution Margin Variance + Total Cost Variance Discretionary Cost Center Discretionary cost centers do not have a clear relationship between inputs and output e.g. legal department, research and development center, human resources and accounting. Flexible budget does not make sense. Non-financial measures of evaluation are the key. 3 Investment Center Evaluation Easy to make profits by simply investing more as investment centers have authority to make investments. So investments centers are evaluated based on profits generated, after taking into account the amount of investment made by the investment center. Two Measures Return on Investment or ROI Residual Income Will learn about them in the topic on Investment Centers 4