Evaluation of Profit Centre and Investment Centre
Understanding Investment Centers
A company’s many departmental divisions are classified as either profit-generating or operating expenditures. Organizational departments are divided into three categories: cost centers, profit centers, and investment centers. A cost center focuses on cost reduction and is measured by the amount of expenditures it incurs.
The cost center includes departments such as human resources and marketing. A profit center is assessed based on the amount of profit created and aims to raise earnings via increased sales or cost reduction. A profit center includes the production and sales departments. Profit and cost centers may take many forms, including divisions, projects, teams, subsidiary firms, manufacturing lines, and machinery.
An investment center is one that is in charge of its own revenues, costs, and assets, as well as managing its own financial statements, which normally include a balance sheet and an income statement. Because expenses, income, and assets must be defined individually, an investment center is often a subsidiary firm or division.
An investment center may be thought of as an extension of the profit center, with revenues and costs tracked. However, only at an investment center are the assets used assessed and compared to the profits earned.
Investment Center vs Profit Center
Instead than focusing on how much profit or expenditure a unit has, like a firm’s profit centers, the investment center focuses on producing returns on fixed assets or working capital invested directly in the investment center.
Unlike a profit center, an investment center may invest in activities and assets that are not directly connected to the company’s operations. It might be investments or acquisitions of other firms that allow the corporation to diversify its risk. A new trend is the emergence of venture arms inside established firms, allowing for investments in the next wave of trends by purchasing interests in startups.
In layman’s terms, a department’s performance is evaluated by assessing the assets and resources allocated to it, as well as how successfully those assets were managed to create income in comparison to its total costs. The investment center concept focuses on return on capital, which provides a more realistic picture of how much a division contributes to the company’s economic well-being.
Using this method of evaluating a department’s performance, managers may choose whether to raise capital to enhance profits or to close a department that is inefficiently using its invested money. An investment center that cannot achieve a return on invested capital greater than its cost is considered unprofitable.
Investment Center vs Cost Center
An investment center differs from a cost center, which does not directly contribute to the company’s profit and is assessed based on the expenses incurred to execute its activities. Furthermore, unlike profit centers, investment centers may use funds to buy other assets.
Because of this complexity, organizations must assess department performance using a number of criteria such as return on investment (ROI), residual income, and economic value added (EVA). A manager, for example, may assess the success of a division by comparing the ROI to the cost of capital. If the ROI is 9% and the cost of capital is 13%, the management might infer that the investment center is not managing its money or assets properly.
Profit Centers
Profit centers are companies inside a bigger firm, such as the various shops that comprise a mall, where managers have responsibility over their own revenues and costs. They often choose the items to purchase and sell, and they have the ability to determine their own rates.
Profit centers are assessed based on controllable margin, which is the difference between controlled revenues and controllable expenses. Exclude any noncontrollable expenses, such as assigned overhead or other indirect fixed costs, from the analysis. The beauty of operating a profit center is that it offers managers an incentive to accomplish precisely what the firm wants: make money.
There are downsides to classifying responsibility centers as profit centers. Although businesses are judged primarily on sales and costs, no one considers their asset utilization. This situation incentivizes managers to exploit excessive assets to increase profits.
Managers benefit from deploying more assets since it leads to increased sales and profits. What’s the downside? Well, nothing; profit center managers are not held responsible for the assets they utilize.
This issue in profit center assessment may be solved by closely monitoring how profit centers utilize assets or simply reclassifying them as investment centers.
Investment Centers
You might call investment centers the luxury automobiles of responsibility centers since they have everything. Investment center managers are in charge of and accountable for their centers’ income, costs, and investments. Return on investment (ROI) is a common metric used to assess their performance.
The management may enhance return on investment by increasing controllable margin (profits) or decreasing average operational assets (productivity).
Using return on investment to assess investment centers eliminates many of the disadvantages associated with analyzing revenue, cost, and profit centers. However, being classified as an investment center may drive managers to prioritize productivity above profitability, working harder to decrease assets (which raises ROI) rather than increasing total profitability.