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Managerial Accounting/Performance Measures/Cost Centers Evaluation

Performance Measures

Contents

Cost Centers Evaluation

Advantages and Disadvantages of Decentralization

Decentralizing performance measures can give greater decision-making accuracy, but it can also lead to contradictory decisions and the lack of a coherent vision for the company.
Unless an organization is small enough that it can be run entirely by just a few people, the leaders in that organization must delegate some level of decision-making authority to others. In a decentralized organization, decision-making authority is spread among many decision makers rather than lying exclusively with the executives at the top of the business. Any organization that is large must decentralize decision-making to some extent, but organizations can still vary greatly regarding how much power they decentralize and how they do so. Decentralization into smaller corporate units within an organization may be based on geographic areas, distribution channels, product lines, customer base, or business function, among other reasons.

Types of Decentralization

Companies that choose to decentralize can divide up power and authority in different ways.
There are many advantages to decentralization. One is that delegation of day-to-day problem-solving tasks to lower-level managers can free upper management to focus on larger issues, such as overall strategy. Also, lower-level managers often have the best firsthand knowledge of day-to-day operations of the business and are in the best position to handle those challenges. The more empowered lower-level employees are, the faster they can respond to customer concerns and changes in the business operating environment. Finally, decentralization allows lower-level managers to earn valuable experience. Empowering them to act with authority in their lower-level managerial positions can help them grow long term at the company as they move into higher-level management positions. Empowered lower-level employees also often report greater job motivation and job satisfaction than their peers in other organizations that are not similarly empowered. There are disadvantages to decentralization as well. Lower-level managers may make decisions that affect the company without fully understanding the company's overall strategy. If decentralization is based on product lines or geographical regions, lower-level managers may make decisions that contradict what other managers at their level are doing in other areas. This can lead to a lack of cohesion in the execution of corporate strategy. Also, lower-level managers may have interests that do not match what is best for the company overall. For example, if their managers judge them on their department's results, then they may be more concerned about how their area of management is doing rather than focusing on what is best for the company overall. Finally, the more decentralized a company is, the harder it is to share best practices and good ideas with other areas of the organization.

Advantages and Disadvantages of Decentralization

In decentralized management, there are multiple decision makers instead of a reliance on top executives. This management structure has benefits and drawbacks.

Cost Center Characteristics

In order to categorize cost centers, it is important to understand how responsibility centers, profit centers, and investment centers all work.

If a manager just has authority over costs but not over revenues or investments, then that manager is considered to be in charge of a cost center. A cost center is a department, unit, or section within a business that requires money to operate. Common cost centers in a business include departments such as finance, administrative, legal, accounting, and human resources, plus individual manufacturing facilities. For example, a large company might have a heavy manufacturing facility, such as a foundry that melts and casts metal to sell to other manufacturers. The same company might also have a light manufacturing facility that assembles products to sell to end users. A manager of a cost center is thus usually evaluated to some extent by how the actual costs their department generated compared to the budgeted cost expectations for that department at the beginning of the year. Companies then make allowances for changes in production or other factors that may have been beyond the manager's control.

While cost managers are ultimately judged on the costs and expenses their unit produces, they can still play a role in generating profits for the organization. For example, in a university setting, the chair of the physics department is not in charge of recruiting students to the university and therefore is not evaluated on overall university enrollment. Instead, the chair is evaluated on managing expenses and costs that the physics department generates. However, because students pay tuition to take classes in that department, they do still play a role in generating profits for the university through tuition dollars.

Decentralized organizations use a responsibility accounting system to tie together lower-level managers' decisions with accountability for the outcome of those decisions. In a responsibility accounting system, lower-level managers have decision-making authority, but they are also accountable for the effect on business that their decisions have.

Other organization structures may provide managers with more authority but also more accountability. Managers that have control or are accountable for areas of cost, profit, or investment within an organization are in charge of a responsibility center. A responsibility center is any part of an organization that is accountable for costs, profits, or investments within that organization. A manager that has control over both costs and revenue, but not over investments within an organization, controls a profit center. A profit center is part of a business that has costs and revenues assigned to it and therefore has profits (or losses) that can be accounted for on a stand-alone basis. An example of a profit center might be an entire product line, such as the SUV division of a car company or all the brands of soda for a foods company. A manager with authority over a profit center will be judged on how they market and sell the product to drive revenues and what they do to limit costs to increase profitability.

An investment center is a business unit within a larger business that is responsible for its own income, expenses, and assets and that can contribute directly to the profitability of the larger business. A manager who controls an investment center is treated almost as if they managed a stand-alone company. That manager has full authority over how to use assets and thus is judged based on the complete results of their area.

<Vocabulary>Return on Investment (ROI)