Tools for Enterprise Performance Evaluation
Some business units have control over both costs and revenues and are therefore evaluated on their profit outcomes. For such profit centers, "cost overruns" are expected if they are coupled with commensurate gains in revenue and profitability.
A restaurant chain may evaluate each store as a separate profit center. The store manager is responsible for the store's revenues and expenses. A store with more revenue would obviously generate more food costs; an assessment of food cost alone would be foolhardy without giving consideration to the store's revenues. For such profit centers, the flexible budgets discussed in this chapter are particularly useful evaluative tools. Other metrics include unit-by-unit profitability analysis using ratio tools introduced in the financial analysis chapter.
At higher levels within an organization, unit managers will be held accountable not only for cost control and profit outcomes, but also for the amount of investment capital that is deployed to achieve those outcomes. In other words, the manager is responsible for adopting strategies that generate solid returns on the capital they are entrusted to deploy. Evaluation models for investment centers become more complex and diverse. They usually revolve around various calculated rates of return.
Many contemporary business successes have occurred in highly decentralized organizations. Top management concentrates on strategy, and leaves the day-to-day operation and decision-making tasks to lower-level personnel. This facilitates rapid "front-line" response to customer issues and provides for identifying and training emerging managers. It can also improve morale by providing each employee with a clear sense of importance that is often lacking in a highly centralized environment. Decentralization can prove a fertile ground for cultivating new and improved products and business processes.
A decentralized environment results in highly dispersed decision making. As a result, it is imperative to monitor and judge the effectiveness of each manager. This is easier said than done. Not all units are capable of being evaluated on the same basis. Some units do not generate any revenue; they only incur costs in support of some necessary function. Other units that deliver goods and services have the potential to be assessed on the basis of profit generation.
As a generalization, the part of an organization under the control of a manager is termed a "responsibility center." To aid performance evaluation it is first necessary to consider the specific character of each responsibility center. Some responsibility centers are cost centers and others are profit centers. On a broader scale, some are considered to be investment centers. The logical method of assessment will differ based on the core nature of the responsibility center.
Obviously most business units incur costs, so this alone does not define a cost center. A cost center is perhaps better defined by what is lacking; the absence of revenue, or at least the absence of control over revenue generation.
Human resources, accounting, legal, and other administrative departments are expensive to support and do not directly contribute to revenue generation. Cost centers are also present on the factory floor. Maintenance and engineering fall into this category. Many businesses also consider the actual manufacturing process to be a cost center even though a saleable product is produced (the sales "responsibility" is shouldered by other units).
It stands to reason that assessments of cost control are key in evaluating the performance of cost centers. This chapter will show how standard costs and variance analysis can be used to pinpoint areas where performance is above or below expectation. Cost control should not be confused with cost minimization. It is easy to reduce costs to the point of destroying enterprise effectiveness. The goal is to control costs while maintaining enterprise effectiveness.
Nonfinancial metrics are also useful in monitoring cost centers: documents processed, error rates, customer satisfaction surveys, and other similar measures can be used. The concept of a balanced scorecard is discussed later in this chapter, and it can be very relevant to evaluating the performance of a cost center.