Performance measures appropriate to profit centres

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Performance measures for cost centres include:

• Profit compared to budget: Profit centres will usually have budgets to work to so this simple comparison is very useful.
• Profit per unit: because a profit centre manager is responsible for costs and revenues, profit per unit produced or supplied is an obvious measure. A simple way to calculate this is to divide the profit for a period by the units produced in the period.
• Gross profit percentage: this is the gross profit divided by sales and expressed as a percentage. It show how many $s of gross profit are generated by each $ of sales. Gross profit can be thought of as the mainspring of profit generation.
• Net profit percentage: this is the new profit divided by sales and expressed as a percentage.
• Expenses/sales: these can be useful ratios to see if expenses (such as administration expenses) are keeping in line with sales.

Performance measures appropriate to investment centres

In an investment centre it will be important to try to judge how well managers have been able to generate profits from the capital invested in the investment centre.

Performance measures for investment centres include:

• Return on capital employed (ROCE): this measure compare the profits earned by the investment centre to the capital invested in the investment centre. Return on capital employed is also known as return on investment (ROI). ROCE is rather like an interest rate: capital is invested in a bank account and income is then received.
• Residual income (RI): this measure makes a notional charge to the investment centre for its use of capital. It takes the view that head office supplies divisions with capital and that capital has to be paid for. The residual income is what’s left if the division had to pay for its use of capital.

An amount of:

Capital employed x interest rate

is deducted from the division’s profits.

Application of performance measures appropriate to cost, profit and investment centres.

Example

Recent results of a division are:

It had been budgeted to produce 100,000 units and these should have taken 5 hours each. In fact, 120,000 units were produced in 580,000 hours.

The capital employed by the division is $4,000,000 and the interest rate is 7%.

Calculate:

• Cost/unit
• Efficiency, capacity utilisation and production volume ratios or percentages
• Gross profit percentage
• Net profit percentage
• Expenses to sales ratio
• ROCE
• RI

Answer to Example

Cost/unit = (3,000,000 + 1,500,000)/120,000 = $37.50

Efficiency percentage = standard hours for production achieved/actual hours.
= 100 x120,000 x 5/580,000 = 103.4%

Capacity utilisation percentage = actual hours worked/budgeted hours
=  100 x 580,000/500,000 = 116%

Production volume ratio = actual production/planned production
= 100 x120,000/100,000 = 120%

Gross profit percentage = 100 x 2,000,000/5,000,000 = 40%

Net profit percentage = 100 x 500,000/5,000,000 = 10%

Expenses to sales = 100 x 1,500,000/5,000,000 = 30%

ROCE = 100 x 500,000/4,000,000 = 12.5%

RI = 500,000 – 7% x 4,000,000 = $220,000