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.
When a responsibility center's
financial performance is measured in
terms of profit centre is called profit
centre.

Conditions for delegating

profit responsibility
To delegate a trade-off decision to a lower
level
manager, two conditions should exist. Which
are as follows:

The manager should have access to relevant

information needed for making such a decision.
There should be some way to measure the
effectiveness of the trade-offs the manager has
made.

Advantages of Profit
Center

Quality of decisions may improve

Speed of operating decisions may be
increased
Relieved of day to day decision making
Profit consciousness
Pressure to improve their competitive
performance
An excellent training ground for general
management
Managers are free to use their imagination
and initiative

Disadvantages of Profit
Center
It will force top management to rely on

management control reports rather than

personal knowledge entailing some Loss of
control
Organization units may be in competition
with one another
Divisionalisation may impose additional cost
Competent manager may not exist
Too much emphasis on short term
profitability at the cost of long run profit
No surety that individual profit center will
optimize the profit of whole organization

Business units as Profit

Centers
Most business units are created as
profit centers
since managers in
charge of such units typically control
product
development,
manufacturing
and
marketing
resources.

Constraints on Business
Unit Authority

Constraints on Business Unit Authority

The Business Unit manager would have to be as
autonomous as president of an independent
company. Practically such autonomy is not
feasible
Constraints from other business units
It is useful to think of managing a profit center in
terms of control over three types of decisions:
1. The product design
2. The marketing decision
3. The procurement or sourcing decision
Constraints from corporate management

Functional units as Profit

Center
Multi-business
companies
are
typically divided into business units,
each of which is treated as an
independent profit generating units.
The functional units which can be
converted into profit centre are as
follows:

Marketing
Manufacturing
Service operations

Contd..
Marketing

Marketing activity can be turned into

profit center by charging it with the cost
of the products sold.

Manufacturing
A manufacturing activity can be turned
into a profit center by crediting it for the
selling price of the products minus
estimated marketing expenses.

Contd.

Service and support units

Units for maintenance, information

Technology,
transportation,
engineering, consulting, customer
service,
and
similar
support
activities can be made into profit
centers.

Measuring profitability
There are two types of profitability
measurements used in evaluating a
profit
centre. They are:
management performance
Economic performance

Types of Profitability
Measures
The performance of profit center
manager, is evaluated by five
different measures of profitability:
1)
2)
3)
4)
5)

Contribution margin
Direct profit
Controllable profit
Income before income taxes
Net income

Proforma of a Profit Centre

income statement
Revenue
(-)Variable expenses
Contribution margin
(-)fixed expenses
Direct profit
(-)controllable charges
Controllable profit
(-)other corporate allocations
Income before taxes
(-) taxes
Net income

xxxx
xxx
xxx
xx
xxx
xx
xxx
xx
xxx
xx
xx

Contd
Contribution Margin
Contribution margin reflects the spread
between revenue and variable expenses.
Direct profit
This measure reflects a profit centers
contribution to the general overhead and
profit of the corporation

Contd.
Controllable profit
It includes expenses that are controllable at
least to a degree, by the business unit
manager.
Income before taxes
In this measure, all corporate overhead is
allocated to profit centers based on the
relative
amount of expense each profit centre incurs .

Contd..
Net income
Net income is arrived after the tax is
deducted
from income before tax.