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Chapter 5

PROFIT
CENTERS

Profit Centers
Profit Centers:
A responsibility centers financial
performance is measured in terms of profit.

General Consideration

In setting up profit center, a company


devolves decision-making power to lower
levels (delegating more authority).

Condition for delegating profit responsibility:


The manager should have access to relevant
information needed for making such decision.
2. There should be way to measure the effectiveness of
the trade-offs the manager has made.
1.

Advantages of Profit Centers

Improve the quality of decisions.


Increase the speed of decision-making.
Headquarters management, relieved of day-today decision making.
Managers are freer to use their imagination &
initiatives
It is an excellent training ground for general
management.
Focus greater attention on profitability.
Responsiveness to pressures to improve their
competitive performance

Difficulties with Profit Centers

Loss of control of the top management.


The quality of decision made may be reduced.
Friction may increase.
Bad competition.
It may imposed additional costs.
Competent general manager may not exist.
Too much emphasis on short-run profitability.
No guarantee of optimizing the profits of the
company as a whole.

Business Units as Profit Centers

Most business units are created as profit


centers. Why?
Constraints on business unit authority:

Constraints from other business units.


Greater degree of integration within a company, the
more difficult it become to assign responsible to a single
profit centers.

Constraints from corporate management.


1. Those resulting from strategic consideration.
2. Those resulting because uniformity is required.
3. Those resulting from the economies of centralization.

Other Profit Centers

Functional Units

Based on the amount of influence (even if not total


control) the units manager exercises over the activities
that effect the bottom line.

Marketing

Charging the marketing dept with the cost of the


product sold.
transfer price
standard cost
When should a marketing activity be given profit
responsibility?
When the marketing manager is in best position to
make the principal cost/revenue trade-offs.

Other Profit Centers

Manufacturing

Must be under appropriate circumstances or


consideration.
Some authors maintain that manufacturing units should
not be made into profit centers unless they sales a large
portion of their output to outside customers.

Service and Supports Units

Ex: Singapore Airlines created profit centers such as


Singapore Airlines Engineering Company & Singapore
Airport Terminal Services (airport services, catering &
security).

Measuring Profitability

Two types of profitability


measurements used in
evaluating a profit centers:
1.

2.

The measure of management


performance, which focuses on
how well the manager doing.
The measure of economic
performance, which focuses on
how well the profit center is doing
as an economic entity.

Types of Profitability Measures


1.

Contribution Margin

2.

Direct Profit

3.
4.
5.

revenue variable expense


Profit centers contribution to the general
overhead & profit of the corporation.

Controllable Profit
Income before Taxes
Net Income

Example of a Profit Center


Income Statement
Profitability Measure
Revenue $ 1,000
Cost of sales
600
Variable expenses..
180
Contribution margin
220
Fixed expenses incurred in the profit center
90
Direct profit
130
Controllable corporate charges.
10
Controllable profit
120
Other corporate allocations
20
Income before taxes
100
Taxes..
40
Net Income
60

(1)
(2)
(3)
(4)
(5)

Revenues

Choosing the appropriate revenue recognition


method.

Management Considerations

Managers should be measured against those


items they can influence, even if they do not
have total control over those items.
Ex: managers should be measured on an aftertax
basis only if they can influence the amount of tax their
unit pays
Items that are clearly cannot influence, such as
currency fluctuation, should be eliminated.

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