Module III

Profit Centers

Objectives

• To discuss the considerations involved in deciding whether to establish a profit center in the first place?

• To discuss, are all the business units are profit centers?• How production and marketing functions can be

constituted as profit centers?• Alternative ways to measure the profit center’s

profitability.

Profit Centers • When a responsibility center’s 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.

2. 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 they are being made by

managers close to the situation.- The speed of operating decisions may be increased since they do not

have to referred to headquarters.- Headquarters are relived form day to day decisions so can concentrate

on broader issues.- Managers can 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 increasing and it increases the overall

profitability of the organization.- Because their output is measured so cautiously profit centers are also

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 and 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. 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.

- 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 manager may not exist in a functional organization because it 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 manager’s authority may be constrained in different way.

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 centersThere can be other profit centers other than the business units.Functional Units:- In some of the business units the 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 center’s day to day activities.

• 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.

Types of Profitability Measures• A profit center’s 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 center’s 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?