CHAPTER 5 :

PROFIT
CENTERS
ALVAREDO ARITONANG
ANDIKA SYAHPUTERA

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

Top
Management

Production
Division

Product A

Product B

Business Unit
Manager

Product A

Product B

Marketing
Division

Product A

Product B

Business Unit
Manager

Product A

Product B

Authority
Delegation
To The
Manager

Profit Centers
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.

Prevalence
of
Profit
Centers
DuPont and GM has a division since the 1920's
But most of the new companies in the U.S. have it after
World War II
Chemical Bank: adopting the concept of profit centers and
eliminate programs that are not profitable and the bank
branch profitability measure more accurately
Novell: to identify and remove some businesses are not
profitable
Nokia: Profit Centers split into six business
responsibilities based on specific market segments.

with

Financial control systems have weaknesses

But still greater benefits
Combined analysis between financial and non-financial.

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.

Difficulties of Profit
Center
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
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 Unit

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.

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.

Constraints from Corporate

Management
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
optimum revenue cost trade off.

for making the

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 center. 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
2) Direct Profit
3) Controllable Profit
4) Income Before Tax
5) Net Income

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.

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

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.

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.

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?