Submitted toDr. Md. Abdul Hannan MiaProfessor Dept. of MISUniversity of Dhaka

Submitted byAbid Hossain KhanRoll: 06-45Management Information SystemsUniversity of Dhaka

Contents

1. What is cost center?

2. Advantages and Disadvantages of cost center.

3. Types of Cost center.

4. How is segment performance measured?

5. Describe the method of segment performance

measured.

6. Solution of the problems related to cost center and

segment reporting from Chapter 12 by Grarrison (13th

edition)

1. What is Cost center?

Cost Center is a segment whose manager has control over costs, but not over revenues or investment funds. Cost center is a business unit that is only responsible for the costs that it incurs. The manager of a cost center is not responsible for revenue generation or asset usage. The performance of a cost center is usually evaluated through the comparison of budgeted to actual costs. The costs incurred by a cost center may be aggregated into a cost pool and allocated to other business units, if the cost center performs services for the other business units.

A cost center can be defined at a smaller level than a department. It could involve a particular job position, machine, or assembly line. Cost centers are not always limited to departments. There might be several cost centers within a department. For example, each assembly line could be a cost center. Even a special machine could be a cost center.

A manufacturer's cost centers include each of its production departments as well as the manufacturing service departments such as the maintenance department or quality control department. Examples of cost centers are as follows:

Accounting departmentHuman resources departmentIT departmentMaintenance departmentResearch & development

Cost centers are usually associated with the topic of decentralization, responsibility accounting, and planning and control. The management focus in a cost center is usually on keeping expenditures down to a minimum level, possibly by using outsourcing, automation, or capping pay levels. The main exception is when a cost center indirectly contributes to profitability (such as R&D), in which case a certain minimum expenditure level will be needed to support sales.

2. Advantages and Disadvantages of Cost center.

The primary purpose of cost centers is to keep track of business segments. Cost center is specific parts of organizations which are created in order to exert budgetary control in a practical manner on that organization. It is the unit within the organization which is responsible only for costs. For example, maintenance department in a manufacturing company/production department.

Advantages-

a. It enhances performance measurement.

b. It enables training of managers in decision making and running the divisions or their center on strict vigilance.

c. It enhances optimization of investments involved to centers identified.d. The quality of accountability and decision may be improved.e. Improved monitoring of investment returnsf. Improved management information on profitability.g. Improved monitoring of costs and expenditure.

Disadvantages-

a. Incorrect allocation of overheads can lead to under or over estimation of profitability.b. Increases administration and paperwork.c. Cost center may add pressures and stress on staff.d. Costs may be hard to allocate accurately to cost center hence making the data from the

center less reliable and in turn less useful.e. Cost center may not be particularly cost effective in itself but it is hard to keep track on

exactly how efficient it really is.

3. Types of Cost center.

Cost Center categories provide the ability to safe guard your postings to cost centers as they will prevent non-category costs being posted to the wrong cost center, in addition it provides greater organizational ability across your cost objects.

i. Production cost center: They represent for those cost center where production or manufacturing activities take place. To be precise, raw materials are converted in to products. Examples are machine shops, welding sections, assembly sections, milling sections etc.

ii. Service cost center: They refer a subsidiary unit to product cost center and they do not produce any product but provide service to product center. Examples are power house, maintenance shop, store, canteen, gas production shop, tool room, personnel office, accounts etc.

iii. Personal cost center: It consists of a person or group of person e.g. sales manager, works manager etc.

iv. Impersonal cost center: It consists a location or an item of equipment (or group of these), e.g. a sales region, a warehouse, a machine or group of machines, etc. A cost center, personal or impersonal, represents organizational span for which separate cost determination is attempted for decision making of management.

v. Process cost center: This type of cost center are engaged on a specific process or a continuous sequence of operations. Here the cost is analyzed and related to a series of operations in sequence. e.g. in refineries, chemical industries, steel rolling etc.

vi. Operation cost center: Operation cost center represents to those machines or persons which carry out similar operations. The purpose is to ascertain the cost of each operation irrespective of its location inside the factory.

4. How is segment performance measured?

The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Large companies are comprised of many business units or segments. A segment may be a division, department, product line, sales territory, or a service center.

A business normally has more than one segment which facilitates specialization in the specific area and results in increased efficiency and profitability. Segments are either a cost center, revenue center, profit center or investment center depending on the nature of their operations and the level of responsibility given to the segment management.

There are two popular metrics that are primarily used in profit and investment centers for judging segment performance: Return on investment (ROI) and Residual income.

Return on investment (ROI) measures the net operating income generated per dollar of investment in operating assets. The higher a business segment’s return on investment, the greater the profit earned pre dollar invested in the segment’s operating assets.

Residual Income (RI) measures the net operating income earned in excess of a required return on operating assets.

ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets.

5. Describe the method of segment performance measured.

There are vital steps when evaluating cost and profit centers. However, evaluating an investment center’s performance requires more than accurate cost and segment margin reporting. In addition, an investment center is responsible for earning an adequate return on investment.

Return on Investment (ROI) Formula

Returnon Investment= NetOpetrating IncomeAverageOperating Assets

Net operating income – income before interest and taxes (or earnings before interest and taxes – EBIT)

Operating assets – include accounts receivable, inventory, plant and equipment and other productive assets; excludes land held for future use, investments in other companies

Average operating assets – average value of the operating assets between the beginning and end of a period

The ROI formula can also be expressed as follows:

ROI = Margin x Turnover

Sales margin – measures a segment’s ability to control its operating costs and to make money on its sales

Capital turnover – measures a segment’s ability to generate revenue for each dollar invested in operating assets

Sales margin and capital turnover constitute the components of ROI and point attention to areas that present improvement opportunities such as increasing sales without increasing operating assets (increases capital turnover) and reducing costs without impairing sales (increases sales margin).There are 3 ways to increase ROII. Increase sales

II. Reduce ExpensesIII. Reduce Assets

It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well-constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI.

Residual IncomeResidual income is the net operating income that an investment center earns above the minimum required return on its operating assets. In equation form, residual income is calculated as follows:

Residual Income = Net Operating Income – Average operating assets × Minimum required rate of return

The Residual Income approach emphasizes maximizing the overall firm value by encouraging managers to invest in projects that earn more than the firm’s cost of capital. The ROI approach, on the other hand, emphasizes maximizing the segment ROI, leading managers to sometimes forego projects that would otherwise improve overall firm value but reduce segment ROI.