When managing a decentralized business structure, a key question is how to measure the performance of responsibility centers. Investment centers are one type of responsibility center where a manager has control over both revenue and costs, including capital expenditures. To analyze investment center performance, a useful metric is economic profit. Economic profit, also called residual income, calculates profit after accounting for the cost of capital required to generate that profit. By explicitly considering capital costs, economic profit helps indicate whether an investment center is generating adequate returns on invested capital.
Economic Profit Metric for Investment Centers
Economic profit is defined as net operating profit after tax (NOPAT) less a charge for capital invested, where the capital charge represents the weighted average cost of capital multiplied by average capital employed. This charge is meant to capture what return investors require on capital supplied to the business unit. If a manager can generate NOPAT above this capital charge, then economic profit is positive, indicating value creation after covering capital costs.
Comparison to Return on Investment (ROI)
Economic profit differs from return on investment (ROI). While ROI evaluates profit generated relative to capital invested, it does not explicitly account for required investor returns. A business unit can show strong ROI but still fail to satisfy capital costs. By directly factoring in cost of capital, economic profit offers a clearer, absolute view of whether capital is being used efficiently.
Advantages of Economic Profit for Performance Measurement
A key advantage of economic profit is incentivizing managers to consider cost of capital in decision making. ROI alone risks managers focusing narrowly on generating high revenue and profit without regard to capital efficiency. Economic profit encourages evaluating both profit level and the amount of capital utilized. This helps steer managers toward decisions expected to earn returns above investor capital costs.
When decentralizing businesses into investment centers, economic profit offers a valuable metric for assessing performance. By accounting for cost of capital, economic profit provides a better indication than ROI for whether business units generate adequate returns on funds invested.