Chapter 5

Profit Centers

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

 To discuss, how business units can be organized as profit centers?

 How production and marketing functions can be constituted as

profit centers?

 Alternative ways to measure the profit center’s profitability.

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 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.

 Profit is a particularly useful performance measure;

 since it allows senior management to use one comprehensive
indicator rather than several

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 General considerations
1. Functional organization
2. Divisionalization

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 1. Functional organization
 Is one in which each principal manufacturing or marketing function
is performed by separate organization unit

2. Divisionalization
 When organization is converted to one in which each major unit is
responsible for both manufacturing and the marketing

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  Companies create business units because they have decided to
delegate more authority to operating managers

 Although the degree of delegation may differ from company to

company, complete authority for generating profit is never
delegated to a single segment of the business

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 Condition 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
for making such a decision

2. There should be some way to measure the effectiveness of the trade-offs

the manager has made.
A major step in creating profit center is to determine the lowest point
in7 an organization where
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Management two conditions prevail
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 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.

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  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 so readily measured, profit

center are particullarly responsive to pressures and
improve their competitive performance

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 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.

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 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.

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 Business units as a profit centers
 Most business units are created as profit center since manager
in charge of such units typically control product development,
manufacturing and marketing resources.

 This manager are in a position to influence revenues and costs and

as such can be accountable for the “bottom line”

However a business units manager’s authority may be constrained

in various ways, which ought to be reflected in a profit center’s
design and operation

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 Constraints on business unit authority
 The business unit manager would have to be autonomous as the
president of an individual company, But as a practical manner such
autonomy is not feasible.

 If a company divided into completely independent units, the

organization would lose the advantages of size & synergy

 Business unit structure represent trade-offs between business unit

autonomy and corporate constraints

 The effectiveness of a business unit organization is largely

dependent on how well those trade off are made.

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  Constraints;
1. Constraints from other Business Units
2. Constraints from Corporate Management

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Constraints from other business units
 one of the main problem occur when business units must deal
with one another

 Its useful to think of managing a profit center in terms of control

over three types of decision;
1. The product decision ( what goods or services to make and
sell?)
2. The marketing decision( how, where, and for how much are
these goods or services to be sold?)
3. The procurement or sourcing decision (how to obtain or
manufacture the goods or services?)
 If a business unit manager control all three activities, there is
usually no difficulty in assigning profit responsibility and
measuring performance.

 In general, the greater the degree of integration within a

company, the more difficult it become to assign responsibility to
a single for all three activity.

 If this three activities decisions for a single product line are split
among two or more business units, separating the
contribution of each business unit to the overall success of the
product line may difficult
  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.

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 Constraints from Corporate Management
 The constraints imposed by corporate management can be grouped into three
types:

1. Resulting from strategic consideration

2. Resulting because uniformity is required
3. Resulting from the economies centralization

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 1. Resulting from strategic decisions: the top
management retains the decisions, especially financial decisions
at corporate level, at least for the domestic activities.

 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.

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  Example,
 Major constraints over Business unit results from corporate
control over new investment.
 Business units compete with one another for a share of the
available fund.

 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

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  Also the maintenance of the proper corporate image may
require constraints on the quality of product or on public
relation activities.

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 2. Resulting because of uniformity requirement:
 Company impose some constraints on business units because of the
necessity for formalities.

 The constraints in terms of accounting system and control

system the business units require uniformity and which may
create problems to the units

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  Examples;
 In 1989 Schering-Plough corp. installed a companywide
accounting and control system. Its take a seven year efforts to
install.

 One major reason the process took so long was the difficulty of
persuading the company’s business units to adopt the corporate
specified system

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

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Other Profit Center
 Functional units
 Multi-business companies are typically divided into business
units, each of which is treated as an independent profit
generating unit.

 The subunits within these business units, however may be

functionally organized

 It’s some time desirable to constitute one or more of the

functional unit-e.g, marketing, manufacturing & service
operations- as profit center
  There is no guiding principle declaring that certain types of
units are inherently profit center and other are not

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 1. MARKETING
 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.

2. MANUFACTURING
 Manufacturing activity 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.

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  Examples ;
 Manufacturing unit should not be made into profit center unless
they sell a large portion of their output to outside customer
 Like outsourcing made by outsider company

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 3. SERVICE AND SUPPORT UNITS
 Service & support units are for maintenance, information
technology, transportation, engineering, consulting, customer service
and the similar activities can all be made into profit centers.

 These may operate out of head quarters and service corporate

divisions.

 They charge customer for service rendered, with the financial

objective of generating enough business so that their revenues equal
their expenses

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  Other organizations
 A company with branch operations that are responsible for
marketing the company’s products in a particular geographical
area is often a natural for a profit center.

 The branch manager have no manufacturing or procurement

responsibilities.

 Like individual stores of most retail chains, individual restaurants

in fast food chains, and the individual hotels in hotel chains are
profit center.

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 Measuring Profitability

 There are two types of profitability measurement used in evaluating

a profit centre;
 Measurement of the management performance
 Measurement of the economic performance.

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  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.

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 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
2. Direct Profit
3. Controllable Profit
4. Income before taxes
5. Net Income

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 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

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 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.

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 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.

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 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.

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 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?

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 THANK YOU

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