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.
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.