Chapter 5

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. The branch or division of a company that creates profits individually and separately from the main organization. The profit center's revenues and expenses are held separate from the main company's in order to determine their profitability.

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. 2. The manager should have access to the relevant information needed to make such decision. There should be some way to measure the effectiveness of the trade-offs the manager has made.

ADVANTAGES OF PROFIT CENTERS

Allow decision making and power to be delegated effectively. Improve speed and efficiency of decision making. Increase motivation now working for a smaller, more local business. Allows more effective use of bonus and other forms of financial motivation all linked to profitability of profit center

 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. 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.

BUSINESS UNIT
A logical element or segment of a company (such as accounting, production, marketing) representing a specific business function, and a definite place on the organizational chart, under the domain of a manager. Also called department, division, or a functional area.

BUSINESS UNITS AS PROFIT CENTERS

Most business units are created as profit centers as the managers are typically control product development, manufacturing, and marketing resources. But, the business unit managers authority may be constrained in different way.

CONSTRAINTS ON BUSINESS UNIT AUTHORITY

The business unit manager has to be given full autonomy as the president of an independent company to get the benefit of profit center system. But, in practical manner this is not feasible. If a company is divided into completely independent units, the organization will lose the advantage of size and synergy. Constraints From Other Business Units: It is useful to think of managing a profit center in terms of control over three types of decisions

Product decision (what goods or services to make or sell) Marketing decision (how, where, and for how much are these goods or services to be sold?) Procurement and sourcing decision (how to obtain or manufacture the goods or services)

 If a business unit manager controls all three activities, there is usually no difficulty in assigning profit responsibility and measuring performance. The greater the integration within a company, the more difficult it become to assign responsibility to a single profit center for all three activity in a given product line.

 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)
iii)

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.

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.

MEASURING PROFITABILITY
There ate 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. 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 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.

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.

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?

Closing chapter 5