This is “Maintaining Control over Decentralized Organizations”, section 11.2 from the book Accounting for Managers (v. 1.0).
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Question: To evaluate performance, organizations often divide operations into segments. Segments responsible for revenues, costs, and investments in assets are called responsibility centersSegments of the organization responsible for revenues, costs, and/or investments in assets and typically defined as cost centers, profit centers, or investment centers.. Responsibility centers can be based on such attributes as sales regions, product lines, or services offered. Why do organizations establish responsibility centers?
Answer: The purpose of establishing responsibility centers within organizations is to hold managers responsible for only the assets, revenues, and costs they can control. For example, a factory manager typically has control over production costs, but not sales. This manager’s responsibility center would only include production costs. A retail store manager typically has control over sales prices and costs. This manager’s responsibility center would only include revenues and costs. The level of control a manager has over a segment’s assets, revenues, and costs will help determine the type of responsibility center used for each manager.
Figure 11.2 "Three Types of Responsibility Centers" illustrates the three types of responsibility centers commonly used to evaluate segments: cost centers, profit centers, and investment centers. Each type is described in the following sections.
Figure 11.2 Three Types of Responsibility Centers
Question: What is a cost center, and what measures are used to evaluate this type of responsibility center?
Answer: A cost centerA segment of an organization responsible only for costs, but not for revenue or investments in assets. is an organizational segment that is responsible for costs, but not revenue or investments in assets. Service departments, such as accounting, marketing, computer support, and human resources, are cost centers. Managers of these departments are evaluated based on providing a certain level of services for the company at a reasonable cost.
Production departments within a manufacturing firm are also treated as cost centers. Production managers are evaluated based on meeting cost budgets for producing a certain level of goods. Chapter 10 "How Do Managers Evaluate Performance Using Cost Variance Analysis?" describes the use of cost variance analysis to evaluate cost centers within a manufacturing firm.
Question: What is a profit center, and what measures are used to evaluate this type of responsibility center?
Answer: A profit centerA segment of an organization responsible for costs and revenues, but not investments in assets. is an organizational segment that is responsible for costs and revenues (and therefore, profit), but not investments in assets. Retail stores for companies, such as Macy’s or Kmart, are treated as profit centers. Individual fast food restaurants for McDonald’s or Kentucky Fried Chicken are also examples of profit centers. Managers of profit centers are responsible for revenues, costs, and resulting profits. (Some individual retail stores and fast food restaurants may be considered investment centers if the store manager is also responsible for large investment decisions, such as enlarging the building and purchasing more equipment to accommodate additional customers. Profit center determination must be made on a case-by-case basis, and it depends on the level of responsibility assigned to the store manager.)
Methods of performance evaluation for profit centers vary. Some organizations compare actual profit to budgeted profit. Others compare one profit center to another. Also, some organizations use segmented income statement ratios, such as gross margin or operating profit, to compare current profit center performance to prior periods and to other profit centers. Chapter 13 "How Do Managers Use Financial and Nonfinancial Performance Measures?" explains how companies can use financial ratios to evaluate profit center performance.
Question: What is an investment center, and what measures are used to evaluate this type of responsibility center?
Answer: An investment centerA segment of an organization responsible for costs, revenues, and investments in assets. is an organizational segment that is responsible for costs, revenues, and investments in assets. Investment center managers have control over asset investment decisions. In many cases, investment centers are treated as stand-alone businesses. Examples of investment centers include the Chevrolet division of General Motors and the printer division of Hewlett Packard.
Several measures can be used to evaluate the performance of investment center managers, including segmented net income, ROI, RI, and economic value added (EVA). The remainder of this chapter will focus on these measures using Game Products, Inc., as the example company. Before turning to these topics, however, look at Note 11.12 "Business in Action 11.3" which indicates the challenges that accountants and managers at Hewlett-Packard face when preparing the company’s annual report.
Segment Reporting at Hewlett-Packard Company
Hewlett-Packard Company provides financial information for seven segments in its annual report. Examples of segments and related revenues (in millions) include HP Services ($15,617), Personal Systems Group ($29,166), and Imaging and Printing Group ($26,786). These segments are likely treated as investment centers where segment managers are responsible for costs, revenues, and investments in assets.
Source: Hewlett-Packard Company, “2006 Annual Report,” http://www.hp.com.
For each of the organizational segments listed, determine whether it is a cost center, profit center, or investment center. Explain your answer.
Solution to Review Problem 11.2