An investment center includes profit and the efficient use of assets. The traditional performance reports only measure revenue and expenses. We need a way work assets into the evaluation.
Typically when we talk about the efficient use of assets whether those assets are buildings, machinery, furniture, or stocks, we look at how much income those assets are generating. With stocks, we look at the gain on the investment and any dividends the stock pays. With company assets, like buildings and equipment, the income generated is company profit. The company uses those assets to produce products and sell those products.
Investment center performance evaluation uses return on investment (ROI) to evaluate performance.
Return on Investment = Operating Income / Total Assets
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.
Profit margin is the percentage of each sales dollars that end up as profit. The higher the percentage, the better the results.
Profit Margin = Operating Income / Sales
Asset turnover tells us how efficiently the company uses assets to generate sales. The company wants to maximize the assets it has to generate as much revenue as it can. These means that the company does not want to have idle equipment or assets that are not in use. This is not a percentage, but the higher the number is the better the results.
Asset Turnover = Sales / Total Assets
Profit margin multiplied by turnover will also give you return on investment.
ROI = Profit Margin X Asset Turnover
This works because sales in the denominator of the profit margin formula cancel out sales in the numerator of the asset turnover formula.
ROI = Operating Income /
Sales X Sales / Total Assets = Operating Income / Total Assets
Investment centers use return on investment to evaluate managers because return on investment measures the efficient use of assets. A higher return on investment means higher efficiency in asset use.
As managers get more decision making responsibilities because of decentralized management, organizations must find ways to evaluate those managers in an effective way. The first step in the process is assigning responsibility centers to each manager.
A responsibility center is a segment of the company for which a manager is responsible. This allows the company to gather quantitative information regarding the segment in order to assess the performance of the manager. There are four types of responsibility centers:
- Cost Center – The majority of managers are responsible for cost centers. A cost center is a segment where the manager is only responsible for managing costs. Examples of cost centers include human resource departments and production departments. These departments are not concerned with revenue generation. Therefore, managers are evaluated on their ability to manage costs. When attempting to determine if a segment is a cost center, determine if revenue is a factor. If revenue is not a responsibility of the manager of the department, the department is a cost center.
- Revenue Center – While revenue is a major factor for most businesses, revenue centers are actually the smallest portion of responsibility centers. Typically, revenue centers are sales territories and sales departments. These managers are evaluated based off their ability to generate revenue. This segment is rare because most managers that are generating revenue are also responsible for managing the costs of generating that revenue.
- Profit Center – These responsibility centers are also quite common. A profit center manager is responsible for generating revenue but also managing costs to increase profitability. These managers include retail managers, like Target or Wal-Mart store managers. These managers must maximize profitability in their stores, but major decisions about asset management (like renovations and improvements) are outside their scope of responsibility.
- Investment Center – While we spend a lot of time discussing profit, asset management is just as important. If assets are not managed efficiently to maximize the profit that can be made with those assets, the company runs the risk of hurting cash flow and future profitability. Managers in an investment center are responsible for asset management and profit maximization. These managers have the ability to approve the construction of new factories, stores, and the purchase of major equipment. Investment center managers include CEO’s of major companies and small business owner-managers. If asset management is involved, the segment is an investment center.