CHAPTER 5

PROFIT CENTERS

When responsibility centers financial performance is measured in terms of profit (i.e.,

by the difference between the revenues and expenses), the center is called a profit center.
Profit is a particularly useful perfomance measure since it allows senior management to use
one comprehensice indicator rather than several (some of which may be pointing in different
directions).
A functional organization is one in which each principal manufacturing or marketing
function is performed by a separate organization unit. As a rule, 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 profits is never delegated to a single segment of the business.
Before delegating profit responsibility to a lower level manager, two conditions should
exist :
(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.
Establishing organization units as profit centers provides the following advantages :
Improved decision quality
Faster operating decision making
Top managers can focus on strategic issues
Managers are more empowered
Training ground for general management
Enhanced profit consciousness
Easy to measure performance
The creation of profit centers may cause difficulties :

The possibility of loss of control by top management

The decision quality may be reduced if top management is more capable than

subordinates
Friction among profit centers
Additional costs (more staff, redundancies)
Overemphasis on short-run profitability

Goal congruence problems

Business Units as Profit Centers

Most business units are created as profit centers since managers in charge of such unit
typically control product development, manufacturing and marketing resources.
Business Units as profit centers have controls over:
One of the main problem occurs when business units must deal with one an-other. It is
useful to think of managing a profit center in terms of control over three types of
decisions :
(1) Product decisions
(2) Marketing decisions
(3) Procurement or sourcing decisions.
Other profit centers:
(1) Marketing
(2) Manufacturing
(3) Service and support units
Measuring Profitability
There are two types of profitability measurements used in evaluating a profit center :

Management performance evaluated by these measures :

(1) Contribution margin
(2) direct profit
(3) controllable profit
(4) income before income taxes
(5) Net income
Economic performance

Revenue recognition problems

Choosing the appropriate revenue recognition method is important. Should revenues be
recorded when :
1. Order made
2. Order shipped
3. Cash received

Management Considerations
Managers should be measured against those items they can influence, even if they do not
have total control over those items.
Most of the confusion is measuring the performance of profit center managers result
from failing to separate the measurement of the manager from the economic measurement of

the profit center. If one considers the measurement of the manager alone, the solution often
becomes evident: Managers should be measured against those items they can influence, even
if they do not have total control over those items. In the typical company, these items
probably include all expenses incurred directly in the profit center.

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