Evaluation of Profit Centre and Investment Centre

28th February 2021 0 By indiafreenotes

Understanding Investment Centers

The different departmental units within a company are categorized as either generating profits or running expenses. Organizational departments are classified into three different units: cost center, profit center, and investment center. A cost center focuses on minimizing costs and is assessed by how much expenses it incurs.

Examples of departments that make up the cost center are the human resource and marketing departments. A profit center is evaluated on the amount of profit that is generated and attempts to increase profits by increasing sales or reducing costs. Units that fall under a profit center include the manufacturing and sales department. In addition to departments, profit and cost centers can be divisions, projects, teams, subsidiary companies, production lines, or machines.

An investment center is a center that is responsible for its own revenues, expenses, and assets and manages its own financial statements which are typically a balance sheet and an income statement. Because costs, revenue, and assets have to be identified separately, an investment center would usually be a subsidiary company or a division.

One can classify an investment center as an extension of the profit center where revenues and expenses are measured. However, only in an investment center are the assets employed also measured and compared to the profit made.

Investment Center vs. Profit Center

Instead of looking at how much profit or expenses a unit has as with a firm’s profit centers, the investment center focuses on generating returns on the fixed assets or working capital invested specifically in the investment center.

Unlike a profit center, an investment center might invest in activities and assets that are not necessarily related to the company’s operations. It could be investments or acquisitions of other companies enabling diversification of the company’s risk. A new trend is the proliferation of venture arms within established corporations to enable investments in the next wave of trends through acquiring stakes in startups.

In simpler terms, the performance of a department is analyzed by examining the assets and resources given to the department and how well it used those assets to generate revenues compared with its overall expenses. By focusing on return on capital, the investment center philosophy gives a more accurate picture of how much a division is contributing to the economic well-being of the company.

Using this approach of measuring a department’s performance, managers have insight as to whether to increase capital to increase profits or whether to shut down a department that is inefficiently making use of its invested capital. An investment center that cannot earn a return on invested funds in excess of the cost of those funds is deemed not economically profitable.

Investment Center vs. Cost Center

An investment center is different from a cost center, which does not directly contribute to the company’s profit and is evaluated according to the cost it incurs to run its operations. Moreover, unlike a profit center, investment centers can utilize capital in order to purchase other assets.

Because of this complexity, companies have to use a variety of metrics, including return on investment (ROI), residual income, and economic value added (EVA) to evaluate the performance of a department. For example, a manager can compare the ROI to the cost of capital to evaluate a division’s performance. If the ROI is 9% and the cost of capital is 13%, the manager can conclude that the investment center is managing its capital or assets poorly.

Profit centers

Profit centers are businesses within a larger business, such as the individual stores that make up a mall, whose managers enjoy control over their own revenues and expenses. They often select the merchandise to buy and sell, and they have the power to set their own prices.

Profit centers are evaluated based on controllable margin; the difference between controllable revenues and controllable costs. Exclude all noncontrollable costs, such as allocated overhead or other indirect fixed costs, from the evaluation. The beautiful thing about running a profit center is that doing so gives managers an incentive to do exactly what the company wants: earn profits.

Classifying responsibility centers as profit centers has disadvantages. Although they get evaluated based on revenues and expenses, no one pays attention to their use of assets. This scenario gives managers an incentive to use excessive assets to boost profits.

For managers, the upside of using more assets is the resulting increases in sales and profits. What’s the downside? Well, nothing; managers of profit centers aren’t held accountable for the assets that they use.

This flaw in the evaluation of profit centers can be addressed by carefully monitoring how profit centers use assets or by simply reclassifying a profit center as an investment center.

Investment centers

You could call investment centers the luxury cars of responsibility centers because they feature everything. Managers of investment centers have authority over and are held responsible for revenues, expenses, and investments made in their centers. Return on investment (ROI) is often used to evaluate their performance.

To improve return on investment, the manager can either increase controllable margin (profits) or decrease average operating assets (improve productivity).

Using return on investment to evaluate investment centers addresses many of the drawbacks involved in evaluating revenue centers, costs centers, and profit centers. However, classification as an investment center can encourage managers to emphasize productivity over profitability to work harder to reduce assets (which increases ROI) rather than to increase overall profitability.