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 centers
profitability.

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.
2.
There should be some way to measure the effectiveness of the tradeoffs 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 managers authority may be
constrained in different way.

Constraints on Business Unit Authority

1.
-.

-.

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.
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 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.
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

1)
-)
-)
-)

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.
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?