Investment Centres

Investment centres represent the ultimate stage in the decentralization of the decision-making process. Divisional managers are made responsible not only for cost goals (expense centres), profit contribution goals (profit centres), but also for elements of the capital invested in the division.

Investment centres extend the principles underlying profit centres by associating divisional profits with the capital invested in the divisions. The criterion most commonly employed for assessing the financial performance Of investment centres is the return on capital employed (ROCE). It is a comprehensive measure of financial performance which enables comparisons to be made between companies and divisions for the purpose of evaluating the efficiency with which assets are utilized. The ROCE is calculated as follows:

ROCE = Net profit before interest and tax 100

Average capital invested

This formula may be extended so as to incorporate the ratio of net profit to sales, and the ratio of sales to capital employed (the rate of asset turnover).

The expanded formula is useful for focusing attention on the important elements which affect the ROCE. It implies that profitability may be improved in the following ways:

(a) by increasing the volume of sales

(b) by reducing total assets

(c) by reducing costs

(d) by improving the profit mark-up, for example by raising selling prices or improving the product mix.

The asset turnover will be improved by (a) and (b), and the profit margin by (c) and (d).

It is clear that division A has the most effective financial performance since its ROCE of 20 per cent is higher than the ROCE of the other two divisions. Division B's return on sales, that is its profit margin, is equal to that of division A, but its asset turnover is half as high as A's, implying that it employs twice as much capital as A to earn the same profit. This position indicates that either sales could be improved or that excessive capital is being carded by division B, and that an investigation of asset use may reveal that plant and stocks could perhaps be reduced. Division C has the same ROCE as division B. Its margin on sales, however, is inferior to that of both other divisions, thereby indicating that selling prices may be too low or that operating costs may be too high.

The foregoing example shows that a ROCE analysis may isolate factors requiring investigation.

Learn More About Management By Objectives

Read on: Variable-cost Transfer Pricing

Transfer prices based upon variable cost are designed to overcome some of the problems stemming from the use of full-cost measurement. Thus, in the aforementioned example, profit centre A would have transferred to profit centre B at a unit price off 10. In the short run, when both profit centres have surplus capacity, this would enable centre B to adopt a more realistic pricing policy to the benefit of the organization as a whole. Such a decision, however, applies only in special circumstances. In the long tim, transfer prices based upon variable costs are of little value for the purpose of performance... see: Variable-cost Transfer Pricing