Corporate organisational structure
A big firm is split into responsibility centres, each with a manager who is answerable for results. The firm may be arranged by function (production, sales, finance), by product, or by region. At the top is the head office; under it are divisions or departments.
- Cost centre: manager controls cost only (a factory, an HR department).
- Profit centre: manager controls cost and revenue (a shop, a product line).
- Investment centre: manager also controls how much money is invested (a division that can buy plant).
Fair judging rule: do not blame a manager for what he or she cannot control.
Methods of performance measurement
Cost centre: compare actual cost with budget. Over budget = unfavourable.
Profit centre: profit = revenue - cost, also compared with budget.
Investment centre has two money measures:
- ROI = profit ÷ investment × 100. A higher percentage is better.
- Residual income (RI) = profit - (investment × required rate). It shows the profit left after paying for the capital used. Positive RI adds value.
Why ROI alone can mislead
A manager with a high ROI may refuse a new project that earns 12% if the division now earns 20%, because it would pull the average down. But if the firm needs only 8%, the project is good for the firm. RI fixes this: any project that earns more than the required rate adds positive RI. That is why many firms use both.
Balanced scorecard: more than money
Money numbers look backward. The balanced scorecard adds four views: finance, customers, internal processes, and learning and growth. For each view the firm picks a few measures, such as profit growth, customer satisfaction, defect rate and training hours. This shows if the firm is building future strength, not just today's profit.
Key formulas and definitions
- ROI = (Profit ÷ Investment) × 100
- Residual income = Profit - (Investment × Required rate)
- Profit = Revenue - Cost
- Cost variance = Actual cost - Budget cost
Worked examples
1. A cost centre had a budget of $50k and actual cost $60k. Find the variance.
60 - 50 = $10k over budget (unfavourable).
2. A shop has revenue $100k and cost $70k. Find its profit.
100 - 70 = $30k.
3. Division X: profit $20k, investment $100k. Find ROI.
ROI = 20 ÷ 100 × 100 = 20%.
4. Required rate is 8%. Find the residual income of X (profit $20k, investment $100k) and Y (profit $30k, investment $250k).
X: 20 - 100 × 0.08 = 20 - 8 = $12k. Y: 30 - 250 × 0.08 = 30 - 20 = $10k. X has higher RI.
5. Y has ROI 12%. The firm needs 8%. Should Y's manager be praised or blamed? Why?
Y earns above the 8% needed, so RI is positive ($10k). It is adding value, even though its ROI is lower than X.
Common mistakes
- Judging a cost centre by profit. It has no sales, so judge it by cost against budget.
- Using profit alone for investment centres and ignoring the money invested.
- Forgetting to multiply by 100 when writing ROI as a percentage.
- Thinking a higher ROI always means a better decision for the whole firm. Check residual income too.