Question

Describe the differences among the cost center, profit center, and investment center. Discuss at least two different measures that can be used to evaluate the performance of an investment center.

Answer 1

Solution. Cost center refers to the part which indirectly incurs an organization cost for operation but does not result directly to its profitability or investment decision. It is recorded and monitored for comparison of budgeted to actual costs of an organization during an accounting period.

Profit center as the name implies accounts for activities which directly results in generation of revenues/gains or losses to an organization during an accounting period. The management of profit center is held responsible for revenue generation activities or decisions undertaken in course of time for an organization to sustain.

Investment center refers to the department accountable for organization's return on investment made by encompassing factors of revenue generation activities and costs are accounted for along with all financial aspects during an accounting period.

Two measures used to evaluate the performance of an investment center are as follows:

a)Return on Investment- ROI is a ratio which measures efficiency of an investment and calculated by taking net profit to capital invested based on historical data accounting. High ROI represents favorable investment gain and vice versa.

b)Residual Income- It is calculated by deducting actual income by desired income. It accounts for excess of income/earnings over minimum rate of return.