A measure frequently used to evaluate the performance of the manager of an investment center is
What Is an Investment Center?An investment center is a business unit in a firm that can utilize capital to contribute directly to a company's profitability. You may compare and contrast some parallels like the terms "profit center" or "cost center." Show
Companies evaluate the performance of an investment center according to the revenues it brings in through investments in capital assets compared to the overall expenses. An investment center is sometimes called an investment division. Key Takeaways
Understanding Investment CentersThe 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 CenterInstead 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 CenterAn 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. Investment centers are decentralized divisions or sub-units for which the manager has maximum discretion in determining not only short-term operating decision on product mix, pricing and production methods, but also level and type of investment. An investment center extends the profit center concept in that the measured profit is related to the center investment. It may be described as a special form of profit center since a profitability measure is being developed for the center. The concept relating profits to assets employed has an intuitive appeal for it for indicates whether the return for the capital invested in the division and it is important that an evaluation be made the overall company are earning on in elaborate systems for authorizing capital investment center performance can be the aggregation of past and present capital projects each project individually. Such a measurement also provides an incentive for division managers to monitor capital investments carefully while managing their operations. The managers will also be motivated to watch the levels of inventory and receivables since these accounts will almost always be included in that investment base. Important Methods of Investment Center Performance EvaluationSome of the important investment center performance evaluation measures are: 1. Return on Investment (ROI)The most common measure of investment center performance evaluation is the return on investment. It is a better test of profitability and is defined as:
The ROI is the result of combination of these two, items: Net Profit Ratio and Capital Turnover. An improvement in either without changing the other will improve the ROI. There are many positive aspects of ROI computation. It is generally an objective measure based on historical accounting data. It facilitates a comparison among divisions of different sizes and in different lines of business. It is a common measure, since it is similar to a cost of capital for which external referents exist in capital markets, while evaluating, the overall corporate profitability, the use of this measure for evaluating divisional performance encourages goal congruence between the division and the firm. Auctions taken by a division to increase its ROI may often increase the overall profitability. Most important, perhaps, the measure focuses’ the division manager’s attention on the assets employed in the division and motivates the manager to invest in, assets only to the extent that an adequate return can be earned on them. If a manager were evaluated only on the level of profits, without regard to assets employed, then the tendency would be to expand assets and thereby increase profits. Such actions will lower the ROI and, therefore, will not take place when ROI is used as a performance measure. Defects of ROI Measure: Actions that increase the divisional ROI may make the division worse off and, conversely, actions that decrease divisional ROI may increase the economic wealth of the division. A similar problem may arise when two divisions with different investment bases are compared. The ROI of two divisions say, A and B are 25% and 30% with capital investment of Rs. 2,00,000 and Rs. 1,00,000 respectively. It might appear that division B is profitable. But on closer examination we find that the division A has Rs. 10,000 more in assets with an incremental earnings of Rs. 20,000, Its incremental ROI is 20 percent well above the cost of capital of 15 percent. Hence, division A is more profitable, after deducting capital costs, than division B. Unfortunately these things may tempt the divisional manager to manipulate the investment bases in, order to, maximize ROI. This problem is caused by evaluating divisional performance attempting to maximize the ROI ratio. 2. Residual Income (RI)To eliminate the problems associated with using a ratio as a performance measure, many companies use the RI approach for investment center performance evaluation. RI is the difference between actual income earned by the division on an investment and the desired income on the investment as specified by minimum desired rate of return. It is calculated as, follows:
Where, Desired income = Maximum desired rate of return x Invested capital In effect, RI is the excess of earnings above the minimum desired earnings. If the firm sets its minimum rate of return at its cost of capital, it must earn an RI that is at least equal to the cost of funds used in making the investment. Any amount of income earned above the cost of capital, is the profit to the firm. The more the income earned above the capital charge, the better off the firm will be. In short, a firm has to maximize its RI. Weaknesses of RI Measure: RI is a less convenient measure than ROI because it is an absolute number, not deflated by the size of the division. It is easier for a much larger division to earn a given amount of residual income than a small division. For example, consider two divisions, one with Rs. 5,00,000 in assets and the second with Rs. 10,00,000 in assets; both have a cost of capital of 15 percent. In order to earn a residual income of Rs. 50,000, the first division would need to earn a net income of Rs. 1,25,000 (an ROI of 25 per cent) whereas the second division would have to earn Rs. 2,00,000 (an ROI of 20 per cent, only). For this reason, most companies using an RI evaluation will not simply direct managers to maximize residual income. Rather they will set budgeted levels of residual income, appropriate for the asset structure of each division, evaluate divisional managers by comparing actual to budgeted residual income. However, this measure also suffers from the same limitation of ROI with regard to the maximization of the economic wealth of the firm. Return on Investment (ROI) Vs. Residual Income (RI) Under ROI the basic objective is to maximize the rate of return percentage. Thus, manager of highly profitable division they are reluctant to invest in the projects with lower ROI than the current rate because their average ROI would tot reduced. On the other hand, under RI the manager would be inclined to invest in the projects earn more than the desired rate of return. 3. Present-Value Depreciation MethodThe PV depreciation method is derived directly from the cash flow schedule used for the appraisal of capital investments, i.e., from the discounted cash flow approach. In this way, a periodic ROI performance measure can be determined such that when actual cash flows equal forecasted cash flows, then each year’s ROI figure will equal the yield (internal rate of return) of the asset. When asset yields equal cash flows over its economic life the PV depreciation method will be identified to the annuity depreciation method. The PV method while incorporating the RI computation, produces more satisfying results. It also offers significant advantages over the straight line method for investment center performance evaluation. Related Posts:
How do you measure the performance of an investment center?The most common measure of investment center performance evaluation is the return on investment. It is a better test of profitability and is defined as: ROI = Net income/Invested capital. ROI = [Net income X Sales (Revenue) ]/[Sales (Revenue) X Invested capital]
What is ROI how is it used in evaluating the performance of investment centers?Investment center performance evaluation uses return on investment (ROI) to evaluate performance. This formula will give you a percentage return on investment similar to what you would see when evaluating stocks. Return on investment can also be calculated by using two other ratios: profit margin and asset turnover.
What are the problems associated with having ROI as a performance measure for evaluating performance of manager of an investment center?Another disadvantage of using ROI as a performance measure is that the manager may not have total control over revenues, expenses, and assets invested. The manager may be bound by contracts entered into by the previous manager. The manager may also have difficulty in disposing of assets purchased by a previous manager.
How can an investment center improve its return on investment ROI?Increase Revenues
One way to increase your return on investments is to generate more sales and revenues or raise your prices. If you can increase sales and revenues without increasing your costs, or only increase your costs enough to still provide a net gain in profits, you've improved your return.
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