Profit centers

Chapter 5

Profit Centers
What is a profit center?
It is a responsibility center whose manager
and other employees control both the
revenues and the costs of the product or
service they sell or deliver.

Advantages of profit center

Quality of decision
Speed of decision
Headquarter may relived from day-to-day decision
free to take Initiative
Excellent training grounds to the managers of
business unit
Profit consciousness
Ready made information to the headquarter
Improves competitive performance

Difficulties with Profit center

It will force top management to rely on management

control reports rather than personal knowledge
Quality of decision making reduces
Friction of transfer pricing increases
Internal competition increases
Additional cost for additional staff
Short run profitability at the cost of long run profit
No surety that individual profit center will optimize
the profit of whole organization

Business unit as profit center

Constraints on business
- Constraints from other business unit
- Constraint from corporate management

Other profit centers

Functional units
- Marketing
- Manufacturing
- Service and support units

Measuring profitability
Contribution margin
Direct profit
Controllable profit
Income before tax
Net income
Revenues

Responsibility Centers
What is an investment center?
It is a responsibility center whose manager
and other employees control the revenues,
costs, and the level of investment in the
responsibility center.

Identify the issues to consider

and basic tools to use in
assessing the performance
of a responsibility center.

Evaluating Responsibility Centers

Underlying the accounting classifications of
responsibility centers is the concept of
controllability.
The controllability principle asserts that
people should only be held accountable for
results that they can control.
It is often difficult to apply the controllability
principle.

Evaluating Responsibility Centers

What are some problems associated with

controllability?
jointly earned revenues and/or jointly
incurred costs
intricate, and often arbitrary, accounting
procedures

Assess the issues and

problems created by revenue
and cost interactions in
evaluating the performance
of an organization unit.

Using Segment Margin Reports

What is a segment margin?
It is the level of controllable profit reported
by an organizational unit or product line.

Using Segment Margin Reports

New Car
Sales
Revenue
$950,000
Variable Costs
750,000
Contribution Margin $200,000
Other Costs
75,000
Segment Margin
$125,000
Allocated Costs
70,000
Income
$ 55,000
Unallocated Costs
Organization Profit

Used Car
Sales
$1,250,000
950,000
$ 300,000
60,000
$ 240,000
80,000
$ 160,000

Total
$2,200,000
1,700,000
$ 500,000
135,000
$ 365,000
150,000
$ 215,000
300,000
($85,000)

Using Segment Margin Reports

What type of problem can occur when

organizations evaluate responsibility
centers as profit centers?
identifying responsibility for the control of
sales and costs

Using Segment Margin Reports

Organizations use two different approaches to
evaluate segment margin numbers:
1 Past performance
Is performance this period reasonable, given
past experience?
2 Comparable organizations
How does performance compare to similar
organizations?

Using Segment Margin Reports

1
2
3

What are some limitations of segment margin

reporting?
Margins can be highly aggregated summaries.
Some segment reports contain arbitrary, or
soft, numbers.
Revenue figures often reflect assumptions
and allocations that can be misleading.

Using Segment Margin Reports

Because of these limitations, interpreting
segment margins should be done carefully.
Other critical success factors should be used
as well to assess performance.

Identify the transfer-pricing

alternatives available to
organizations and the criteria
for choosing a transfer
pricing alternative.