Profit Centers

Profit Centers

When a responsibility centers financial performance
is measured in terms of profit (i.e. by the difference
between revenue and expense) the center is called a
profit center.

General Considerations:

- conditions for delegating profit responsibility: many
management decisions involve proposals to increase
expenses with the expectation to increase the
revenues.




- For delegating this responsibility to any department
head or manager two condition should exists.

1. The manager should have access to the relevant
information needed to make such decision.

1. There should be some way to measure the
effectiveness of the trade-offs the manager has
made.

Contd.
Advantages of Profit Center

Establishing organization units as profit centers provide
different advantages like;

- The quality of decisions may improve as they are being made
by managers closest to the point of decisions.

- The speed of operating decisions may be increased since they
do not have to referred to headquarters.

- Headquarters are relived form day to day decision making
so it can concentrate on broader issues.

- Managers , subject to fewer corporate restraints are freer to
use their imagination and initiative.

- Because the profit centers are running as an independent
business units, it will be a training ground for general
management.

- Profit consciousness is enhanced since managers who are
responsible for profits will constantly seek ways to increase
them.

- Profit centers provide top management with ready made
information on profitability of companys individual
components.

- Because their output is so readily measured , profit centers
are particularly responsive to the pressures and improve
their competitive performance.

Contd.

Difficulties with Profit Centers:

- Decentralized decision making will force top
management to rely more on management control
reports than on personal knowledge of an operation
entailing some loss of control.

- If the headquarters are more capable to generate the
profit, the decision taken at business unit level will be
questioned.

- The departments and functions will be in competition
now with each other. Friction may increase because of
arguments over the appropriate transfer price,
assignment of common costs etc. An increase in profit
for one department may a decrease to another.
- Divisionalization may impose additional cost because of
the additional management, staff personnel, record
keeping etc. and may lead to task redundancies at each
profit center.

- There may be too much emphasis on short run
profitability at the expense of long term profitability
and growth.

- There is no complete satisfactory system to ensure that
divisional profit will contribute in the profitability of the
whole organization or not.

- Competent general managers may not exist in a
functional organization because they may not have
opportunity for development
Business Units as Profit Centers

Most business units are created as profit centers as the
managers are typically looking after product
development, manufacturing, and marketing resources.

These managers are responsible for cost and revenue
as well as accountable for the activities they did.

But, the business unit managers authority may be
constrained in various ways, which ought to be
reflected in a profit centers design and operation.





Constraints on Business Unit Authority

- The business unit manager has to be given full
autonomy to get the benefit of profit center system.
But , in practical manner this is not feasible.

- Because, if a company is divided into completely
independent units, the organization will lose the
advantage of size and synergy. Thus, there are
certain constraints that companies are facing.

1. Constraints from other business units: there can be
problems from other business units if they all are
interdependent and given the responsibility as profit
center.



- when the business units are interrelated for the
products to produce, for the marketing strategies, for
the process of manufacturing, the decisions are
delayed and each and every business unit is working
for their own profit.


- Overall performance measurement of a particular
business unit is not possible as it taking major things
or synergies from other business units.


Contd.

2. Constraints from corporate management: the
constraints imposed by corporate management can
be grouped into three types:

i) Resulting from strategic decisions: the top
management retains the decisions, especially
financial decisions at corporate level.
- business units are competing with each other for the
budgets.
- Management is also imposing the constraints
regarding marketing, production activities that it is
permitted to undertake.
- Thus, a business units might be finding some
expansion plan, but unable to implement if the top
level doesn't permit as per the limits of the business
units.




ii) Resulting because of uniformity requirement: the
constraints in terms of accounting system and
control system the business units require uniformity
and which may cerate problems to the units.


iii) Resulting from economies of centralization: in case of
centralize structure, the management may impose
uniform pay, personnel policies, vendor selection,
communication equipments etc. which may cerate
problems to business units.


Other profit centers
There can be other profit centers other than the
business units.

Functional Units:

- In some of the business units the functional
departments are also treated as profit centers.

- Marketing activity can be turned into a profit center by
charging it with the cost of the products sold.

- This transfer price provides the information for making
the optimum revenue cost trade off.




- Manufacturing is usually an expense center, and
generating different costs. Thus, are not considered as
the profit center unless they are selling majority of the
products to outside customers.


- Service and support units are for maintenance,
information technology, transportation, engineering,
consulting, customer service and the similar activities
can be provided with in and outside the organization
but on charged basis. Then they are considered as the
profit centers.

Measuring Profitability
There are two types of profitability measurement used in
evaluating a profit centre. They are measurement of the
management performance and measurement of the economic
performance.

The management performance focuses on how well the
manager is doing. This measure is used for planning,
coordinating and controlling the profit centers day to day
activities and as a device for providing the proper motivation
for its manager.

While the economic performance is focuses on how well the
profit center is doing an economic activity.

The necessary information for both purposes are taken from
different department and reports are made for the same.

Profitability Measures

REVENUE
Less: Cost of Sales
Less: Variable expenses
CONTRIBUTION MARGIN
Less: Fixed Expenses incurred in the profit center
DIRECT PROFIT
Less: Controllable corporate charges
CONTROLLABLE PROFIT
Less: Other corporate allocations
INCOME BEFORE TAXES
Less: Taxes
NET INCOME

Types of Profitability Measures
A profit centers economic performance is always
measured by net income. The performance of the
profit center manager is evaluated by five different
measures of profitability.

1) Contribution Margin
- Contribution margin reflects the spread between
revenue and variable expenses.

- The profit center manager can increase the
contribution margin by increasing the sales and
decreasing the cost.

- The fixed cost are beyond the control, but there can
be changes into the discretionary costs.
Contd.


2) Direct Profit

- This measure reflects a profit centers contribution to
the general overhead and profit of the organization.
- It incorporates all the expenses directly traceable to
the profit either it is from the same department or any
other department.

- A weakness of the direct profit measure is that it does
not recognize the motivational benefit of charging
headquarters cost.
3) Controllable Profit

- Headquarters expenses can be divided into two
categories: controllable and uncontrollable.

- Controllable expenses are those which can be
controlled at certain level like information technology
or services. Thus, the profit centers can take the burden
and generate the level of profit which can be compared
with the industry profit.

- While if the profit centers are taking the uncontrollable
cost of the headquarters they are unable to generate
moderate level of continued profits.

Contd.
4) Income before taxes:

- In this measure, all corporate overhead is allocated to
profit centers based on the relative amount of expense
each profit center incurs. Means, no profit center is
taking the headquarters cost.

5) Net Income:

- Here the companies measure the performance of
domestic profit centers according to the bottom line,
means the amount of net income after income tax.
- Choosing the appropriate revenue recognition method
is important. Should revenues be recorded when an
order is placed, when an order is shipped or when cash
is received?