 Hello and welcome to the session in which we would look at performance measurement. Before we discuss performance measurement we have to understand that the company might break down for internal performance valuation its centers or its divisions by four different categories. Revenues, cost, profit and investments. Before we discuss those four divisions I would like to remind you that if you are an accounting student or a CPA candidate because this topic is covered in cost accounting, managerial accounting as well as the CPA exam especially if you are taking the CPA exam I strongly suggest you check out my website farhatlectures.com. I do not replace your Becker, your Roger, your Glyme or your Wiley so if you're taking a CPA course good for you you need to take a CPA course. I can be a useful addition I can add 10 to 15 points to your CPA exam. 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So let's talk about the four different responsibility centers real quick okay the first one is revenue center what is a revenue center it's a division that only generates sales and it's not responsible for any cost or expenses the most classic example of revenue center is a sales division so you're you're you're you're evaluating you're saying okay yes this is my sales division and I'm going to evaluate you based on sales another division could be cost centers where they only generate costs and they are not responsible for generating any revenue that's not how you evaluate them those two responsibility centers they are measured by variance basically there's a budget there's a goal and how well did you achieve that goal obviously for revenues you want to be higher for cost you want to be lower now what about if a division or as a center is considered a profit center basically a profit center is considered for both revenues and cost that's or expenses so incur both revenues and expenses so simply put we should be very familiar with this idea of revenue minus expenses here the profit center is a goal oriented center because we we are taking revenues minus expenses when I say center think of a division okay like the the Dunder Mifflin office in Scranton that could be its own center profit centers where they are responsible for revenues they generate revenues they sell papers and they also incur costs they have employee costs they have rent costs taxes so on and so forth now for external users this sounds familiar familiar as well because when you evaluate a company you want to see how well how profitable they are so this is should be kind of familiar for us because at this point you took financial accounting but here we are using the profit for internal for internal purposes to reward managers so the way we compute profit here could be a little bit different that could be most likely it's a little bit different than external than external gap and how do we break down those centers well it could be done by a geography product line so on and so forth anything that make sense to the company remember this is an internal assessment this is not for external purposes therefore you don't have to use gap you don't have to use gap rules in other words consider only the cost which which is under the management control so if the cost is kind of assigned to the company because assigned by the corporate because of gap purposes we don't really use it in a sense it's not really it's not really assessing the internal performance of that division okay so cost may be under gap but not under the manager's division now in the next session we would look at investment centers investment centers look at revenues look at cost but also we're going to add to it assets and this is will be the next session when we look at investment centers so what are the advantages and disadvantages for using profit centers one one it's easy to understand again revenue minus expenses now the way we account for revenues the way we account for expenses could be little bit different nevertheless the big picture is the same and we are looking at the manager's effort and decision in generating revenues and incurring cost so that's why managers like this because it's directly related to their effort and basically we're assessing the revenues and expenses of that particular division so and it's easy for the corporate division to compare the corporate the corporate headquarter to compare divisions because we're looking at revenues and expenses now the disadvantages of this is divisions could be of different sizes but we can find the solution we could compute compute percentages but nevertheless they could be of different sizes or in different locations which will make a difference okay and it does not really the profit centers does not really does not really evaluate the use of the assets how well the manager is using the assets okay because it's only looking at revenues and expenses but how efficient are they are they and using the assets under their control therefore to evaluate to evaluate the division we're going to be using profitability ratios and we're going to be looking at two profitability ratios one is the gross margin and one is the profit margin they both have the word margin in them we have to understand the difference between gross and profit or sometimes it's called net profit so what is the gross margin ratio well you have to know what the gross margin is the gross margin is sales minus cost of goods sold so if i'm if my total sales is 100 my cost of goods sold is 60 i would say my gross profit my gross margin is 40 dollars now notice i said dollars this is a dollar amount when you compute the gross margin now i'm going to compute the gross margin percentage or the ratio which i'll take the gross margin 40 dollars divided by 100 and that's going to give me for my example 40 and this is the ratios that i am looking at it shows you how well the managers control cost of goods sold in the relationship to sales simply put for this example for every dollar in sales we pay 60 pennies in cost of goods sold and we have 40 cent in profit now why do we use ratios because now it's easy to understand one to compare not to understand to compare one division to the other and you will see this in a moment when we look at an example so this tells us how well the managers have control over cost of goods sold okay so notice for the gross margin other operating costs are ignored we're only looking at cost of goods sold so to include to have more expenses included in the computation we would look at net profit margin ratio or profit margin ratio now how we measure profit because this is a profit or net profit well we could measure profit as only operating income or we can measure profit as net income which is operating profit minus taxes which is income after taxes and some textbook they use operating income some text some text book they use net income but the concept net this is income net income the concept is you are looking at the bottom line how much the company is keeping an every dollar in sales keeping in profit okay so operate so the way we compute this it's operating profit divided by sales again how we compute operating profit it's you know we could use those two measures it's also called sometimes called operating profit margin ratio if you're using operating income it's better to use operating profit margin ratio if you're using net income you would call it net profit margin so don't get confused with the name it's some sort of measurement divided by total sales so income after taxes divided by sales which is this is net income net income so what is the takeaway from all of this it's how much are we keeping in profit after accounting for cost of goods sold using the first ratio which is 40 percent and let's assume let's keep going with this example so 100 minus 60 equal to 40 this is the gross profit and let's assume operating expenses we have 30 dollars so we are keeping this these are the operating expenses okay so now we have operating income of 10 dollars now we if we compute the profit margin ratio 10 divided by 100 is 10 percent it means for this company for every 100 dollar in sales we are keeping 10 percent in profit now let's take a look at an actual example not an actual but you know a more comprehensive example let's assume we're looking at Dunder Mifflin and we're comparing the New York Division to the Scranton Division and we have sales for every division minus cost of goods sold gives us profit gross margin for the New York Division 20 million for the Scranton 12 million then we have operating expenses 12 million in New York 8 million in Scranton then we compute operating income 8 million for New York 4 million in Scranton now by looking at only but by looking at only at the numbers you would say well the New York Division is doing much better their operating income is twice that of Scranton but let's look let's let's let's look a little bit further we compute the taxes and we get after tax income okay so looking at operating income it looks like New York does better looking at gross margin also New York is better but that's not really a fair comparison remember if you operate in New York okay especially in New York City you have more businesses to sell paper to versus if you are operating in Scranton in Pennsylvania middle of nowhere okay so what we have to compute is first is the gross margin ratio how much are we keeping after we deducting our cost well the New York Division is keeping 40 cent per every dollar Scranton Division is keeping 60 cent for every dollar so notice the Scranton Division is doing a better job in controlling their cost of goods sold okay their cost of goods sold it means it's 40 percent and 60 percent profit in New York it's the opposite we have 60 percent cost and 40 percent profit okay so notice Scranton is doing a better job somehow they are buying supplies from a cheaper place or somehow they're closer to their suppliers somehow somehow it's cheaper then we can compute the the profit margin ratio which is taking operating income divided by sales operating income divided by sales and what we notice here New York they're keeping 16 pennies for every one dollar in sales the Scranton Division is keeping 20 cent one fifth of every dollar they keep it in sales obviously the Scranton Division is doing a better job but the New York Division is definitely larger and this should make sense if you're operating in New York especially in New York City so notice what we did after we looked at the numbers we want to know compare them on the same level compare them on the same level you would use per percentages and this is how we'll be able to reward employees reward divisions and everyone is happy at the end of this recording i'm going to invite you again to check out my website especially if you are an accounting 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