Assignment on

Cost Center &

Segment Performance
Measurement

Submitted to
Dr. Md. Abdul Hannan Mia
Professor
Dept. of MIS
University of Dhaka

Submitted by
Abid Hossain Khan
Roll: 06-45
Management Information
Systems
University 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 department
Human resources department
IT department
Maintenance department
Research & 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.

department

in

manufacturing

company/production

Advantagesa. 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 returns
f. Improved management information on profitability.
g. Improved monitoring of costs and expenditure.
Disadvantagesa. 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.

ii.

iii.
iv.

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

v.

vi.

impersonal, represents organizational span for which separate cost

determination is attempted for decision making of management.
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.
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 segments return on investment, the greater the profit earned pre
dollar invested in the segments 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 centers 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
Net Opetrating Income
Return on Investment=
Average Operating 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 segments ability to control its operating costs

and to make money on its sales
Capital turnover measures a segments 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 ROI
I. Increase sales
II. Reduce Expenses
III. 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 companys
strategy. A well-constructed balanced scorecard can provide managers with
a road map that indicates how the company intends to increase ROI.

Residual Income
Residual 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 firms
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.