Meaning and Components of Performance Evaluation

In this article we will discuss about the meaning and components of performance evaluation.

Meaning of Performance Evaluation:

Performance evaluation is the basis of a management control system. Periodic comparisons of the actual costs, revenues and investments with the budgeted costs, revenues and investments can help management in taking decisions about future allocations.

Performance evaluation should be done in respect of all responsibility centres (i.e., cost centres, profit centres and investment centres) to ascertain their level of performance. The best way to encourage managers to achieve the desired level of performance is to measure their performance in comparison to budgeted results.

Performance evaluation of employees is used in taking decision about their salaries, promotions and training required for future assignments.

According to Gary Dessler:

“Appraising performance serves two main functions. First performance appraisals are the basis on which various administrative decision are made, decisions that include salary increases, promotions and transfers. Performance appraisal also serves as a work planning and review function. The appraisal and subsequent superior/subordinate review provide an opportunity to review your subordinate’s progress and to make out a plan for rectifying any problems that might be identified.”

Components of Performance Evaluation:

Performance evaluation is to be made of:

a. Cost centre,

b. Profit centre or 

c. Investment centre. 

a. Cost Centre:

A cost centre is the smallest segment of activity or area or responsibility for which costs are accumulated. Typically cost centres are departments but in some instances, a department may contain several cost centres.

These cost centres are the departments or sub-departments of an organisation with reference to which cost is collected for cost ascertainment and cost control. For example, although an assembly department may be supervised by one foreman, it may contain several assembly lines.

Sometimes each assembly line is regarded as a separate cost centre with its own assistant foreman. A cost centre can be a location, i.e., an area such as department, storeyard or sales area or an item of equipment, e.g., lathe machine, delivery vehicle or a person, e.g., salesman, foreman.

The determination of a suitable cost centre is very important for ascertainment and control of cost. The manager in-charge of a cost centre is held responsible for control of cost of his cost centre. It enables the accumulation of all such costs at one place for which a common base of recovery may be used.

Types of Cost Centres:

Cost centres may be classified as under:

(i) Personal and Impersonal Cost Centres:

Personal cost centre is one which consists of a person or a group of persons. On the other hand, impersonal cost centre consists of a machine, a department or plant.

(ii) Operation and Process Cost Centres:

Operation cost centre consists of those persons and/or machines carrying out the same kind of operation. On the other hand a centre which has a continuous sequence of operations is called process cost centre.

(iii) Product and Service Cost Centres:

Product centre refers to a centre through which a product passes and generally corresponds to a product department. In such centres, raw materials are converted into finished goods. Service centre is a department or centre which incurs direct and indirect costs but does not work directly on products.

Maintenance department and general factory office are examples of such centre. Such centres are ancillary and render service to production centres to enable them to carry out the work of production smoothly. The numbers of cost centres vary from organisation to organisation.

In engineering industry, the cost centres may be:

(i) Machine shop,

(ii) Welding shop,

(iii) Assembly shop,

(iv) Maintenance department,

(v) General administrative department; (i) to (iii) centres are production centres whereas (iv) and (v) centres are service cost centres.

b. Profit Centre:

A profit centre is that segment of activity of a business which is responsible for both revenue and expense and discloses the profit of a particular segment of activity. Profit centres are created to delegate responsibility to individuals and measure their performance. Profit centre is different from cost centre.

Following are the main points of difference between a cost centre and profit centre:

(i) Cost centre is the smallest unit of activity or area of responsibility for which costs are collected whereas a profit centre is the segment of activity of a business which is responsible for both revenue and expenses.

(ii) Cost centres are created for accounting conveniences of costs and their control whereas a profit centre is created because of decentralisation of operations i.e., to delegate responsibility to individuals who have greater knowledge of local conditions etc.

(iii) Cost centres are not autonomous whereas profit centres are autonomous.

(iv) A cost centre does not have target costs but efforts are made to minimise costs, but each profit centre has a profit target and enjoys authority to adopt such policies as are necessary to achieve its targets.

(v) There may be a number of cost centres in a profit centre as production or service cost centres or personal or impersonal but a profit centre may be a subsidiary company within a group or division in a company.

c. Investment Centre:

It is a centre in which a manager can control not only revenues and costs but also investments. The manager of such centre is made responsible for properly utilizing the assets used in his centre. He is expected to earn a requisite return on the amount employed in assets in his centre.

Return on investment is used as a basis of judging and evaluating performance of an investment centre. Many large firms in U.S.A. like General Motors etc. follow this system of management control.

Performance of an investment centre is assessed not by profit alone; rather profit is related to investment employed in the centre. The manager of an investment centre is required to earn a satisfactory return on capital employed in the centre.

Performance report of an investment centre in absolute money terms would be like a performance report of a profit centre, but in addition the report would also mention the amount of investment employed in the investment centre. Return on capital employed in the investment centre along with desired rate of return should also be given in the performance report.

An investment centre may be treated as a separate centre of business where the manger has overall responsibility of managing inputs (i.e. expenses or costs), outputs (i.e. revenues) and investment. Managers of subsidiary companies can be treated as investment centre managers, accountable for costs, profits and capital employed.