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.
One popular method was pioneered by E. I. du Pont de Nemours and Company. It is commonly known as the DuPont return on investment (ROI) model, and is pictured at right. This model consists of a margin subcomponent (Operating Income/Sales) and a turnover subcomponent (Sales/Average Assets). These two subcomponents can be multiplied to arrive at the ROI. Thus, ROI = (Operating Income/ Sales) X (Sales/Average Assets). A bit of algebra reveals that ROI reduces to a much simpler formula: Operating Income/ Average Assets.
But, a prudent manager who is to be evaluated under the ROI model will quickly realize that the subcomponents are important. Notice that ROI can be increased by any of the following actions: increasing sales, reducing expenses, and/or decreasing the deployed assets. The DuPont approach encourages managers to focus on increasing sales, while controlling costs and being mindful of the amount invested in productive assets. A disadvantage of the ROI approach is that some "profitable" opportunities may be passed by managers because they fear potential dilution of existing successful endeavors. The consulting firm of Stern, Stewart & Co. has trademarked and popularized the Economic Value Added model as an alternative comprehensive evaluative tool for assessing investment returns. Presumably, it compensates for the deficiencies of simpler models. Advanced managerial accounting courses typically devote considerable coverage to the various approaches to evaluating investment centers.
Lower-level managers may only be responsible/accountable for a small subset of business activities. As one moves up the organizational chart, mid and upper-level managers assume ever greater degrees of responsibility. The reporting system should mimic the expanded scope, and develop information which reveals the performance for all units within the control of a particular manager. At successively higher steps, individual performance reports are combined to reveal the success or failure of all activities beneath a particular manager. This can result in one manager being held accountable for a combination of cost, profit, and investment centers. A keen manager must be familiar with the specific techniques for managing and gauging the success of each!
Following is an organization chart for Out To Lunch Hamburgers. Out to Lunch is a rapidly growing fast-food restaurant chain. Their business model revolves around a uniquely flavored hamburger, and a very simple menu consisting of a hamburger, fries, and drinks. They provide simple "round number" pricing, few products, and rapid service. Out to Lunch also has a catering service for sporting events, corporate outings, and similar occasions.
The block colors in the organization chart indicate the character of performance/responsibility evaluation that is germane to each position. The Chief Executive Officer reports to the owners, and the owners are primarily interested in their return on investment. Three vice presidents report to the CEO:
The VP of operations is responsible o for the overall investment in operations, which is driven heavily by the combined profits of each store. The VP of Operations oversees procurement, store management, and catering management.
- The Procurement Manager oversees purchasing of food and dishware.
- The Procurement activities are evaluated as cost centers, relying on budgets and standard costs to control activities.
- The Store and Catering managers oversee supervisors from each location.
- The Store and Catering Managers are responsible for producing profits, and are evaluated accordingly.
- The VP of Finance is viewed and evaluated as a cost center.
- The VP of Real Estate is responsible for site acquisition and construction. Although the activities are largely viewed in the context of a cost center, there is an expected rate of return for each new real estate investment. Therefore, the VP of Real Estate is evaluated for cost control and return on investments.