Q:2) Every SBU is a profit center but every profit center is not a SBU?

? What are the conditions that

should be fulfill for an organization unit to be converted into a profit center? What are the different
ays to !easure the perfor!ance of profit center? "iscuss their relevant !erits and de!erits#
$ns:
%ypes of &rofitability 'easures
A profit center's economic performance is always measured by net income (i.e., the income remaining after
all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The
performance of the profit center manager, however, may be evaluated by five different measures of
profitability: (1) contribution margin, () direct profit, (!) controllable profit, (") income before income
ta#es, or ($) net income
()) *ontribution 'argin:
%ontribution margin reflects the spread between revenue and variable e#penses. The principal argument in
favor of using it to measure the performance of profit center managers is that since fi#ed e#penses are
beyond their control, managers should focus their attention on ma#imi&ing contribution. The problem with
this argument is that its premises are inaccurate' in fact, almost all fi#ed e#penses are at least partially
controllable by the manager, and some are entirely controllable. (any e#pense items are discretionary' that
is, they can be changed at the discretion of the profit center manager. )resumably, senior management
wants the profit center to *eep these discretionary e#penses in line with amounts agreed on in the budget
formulation process. A focus on the contribution margin tends to direct attention away from this
responsibility. +urther, even if an e#pense, such as administrative salaries, cannot be changed in the short
run, the profit center manager is still responsible for controlling employees' efficiency and productivity.
(2) "irect &rofit:
This measure reflects a profit center's contribution to the general overhead and profit of the corporation. ,t
incorporates all e#penses either incurred by or directly traceable to the profit center, regardless of whether
or not these items are within the profit center manager's control. -#penses incurred at head.uarters,
however, are not included in this calculation. A wea*ness of the direct profit measure is that it does not
recogni&e the motivational benefit of charging head.uarters costs.
(+) *ontrollable &rofit:
/ead.uarters e#penses can be divided into two categories: controllable and non controllable. The former
category includes e#penses that are controllable, at least to a degree, by the business unit manager0
information technology services, for e#ample. ,f these costs are included in the measurement system, profit
will be what remains after the deduction of all e#penses that may be influenced by the profit center
manager. A ma1or disadvantage of this measure is that because it e#cludes non controllable head.uarters
e#penses it cannot be directly compared with either published data or trade association data reporting the
profits of other companies in the industry.
(,) -nco!e before %a.es:
,n this measure, all corporate overhead is allocated to profit centers based on the relative amount of
e#pense each profit center incurs. There are two arguments against such allocations. +irst, since the costs
incurred by corporate staff departments such as finance, accounting, and human resource management are
not controllable by profit center managers, these managers should not be held accountable for them.
2econd, it may be difficult to allocate corporate staff services in a manner that would properly reflect the
amount of costs incurred by each profit center.
There are, however, three arguments in favor of incorporating a portion of corporate overhead into the
profit centers' performance reports. +irst, corporate service units have a tendency to increase their power
base and to enhance their own e#cellence without regard to their effect on the company as a whole.
Allocating corporate overhead costs to profit centers increases the li*elihood that profit center manager3
will .uestion these costs, thus serving to *eep head office spending in chec*. (2ome companies have
actually been *nown to sell their corporate 1ets because of complaints from profit center managers about
the cost of these e#pensive items.) 2econd, the performance of each profit center will become more realistic
and more readily comparable to the performance of competitors who pay for similar services. +inally, when
managers *now that their respective centers will not show a profit unless all0costs, including the allocated
share of corporate overhead, are recovered, they are motivated to ma*e optimum long0term mar*eting
decisions as to pricing, product mi#, and so forth, that will ultimately benefit (and even ensure the viability
of) the company as a whole.
,f profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the
basis of budgeted, rather than actual, costs, in which case the 4budget4 and 4actual4 columns in the profit
center's performance report will show identical amounts for this particular item. This ensures that profit
center managers will not complain about either the arbitrariness of the allocation or their lac* of control
over these costs, since their performance reports will show no variance in the overhead allocation. ,nstead,
such variances would appear in the reports of the responsibility center that actually incurred these costs. .
(/) 0et -nco!e:
/ere, companies measure the performance of domestic profit centers according to the bottom line, the
amount of net income after income ta#. There are two principal arguments against using this measure: (1)
after ta# income is often a constant percentage of the preta# income, in which case there would be no
advantage in incorporating income ta#es, and () since many of the decisions that affect income ta#es are
made at head.uarters, it is not appropriate to 1udge profit center managers on the conse.uences of these
decisions. There are situations, however, in which the effective income ta# rate does vary among profit
centers. +or e#ample, foreign subsidiaries or business units with foreign operations may have different
effective income ta# rates. ,n other cases, profit centers may influence income ta#es through their
installment credit policies, their decisions on ac.uiring or disposing of e.uipment, and their use of other
generally accepted accounting procedures to distinguish gross income from ta#able income. ,n these
situations, it may be desirable to allocate income ta# e#penses
to profit centers not only to measure their economic profitability but also to motivate managers to minimi&e
ta# liability.
'erits:
The .uality of decisions may improve because they are being made by managers closest to the
point of decision.
The speed of operating decisions may be increased since they do not have to be referred to
corporate head.uarters. . /ead.uarters management, relieved of day0to0day decision ma*ing, can
concentrate on broader issues.
(anagers, sub1ect to fewer corporate restraints, are freer to use their imagination and
initiative.5ecause profit centers are similar to independent companies, they provide an e#cellent
training ground for general management. Their managers gain e#perience in managing all
functional areas, and upper management gains the opportunity to evaluate their potential for
higher0level 1obs.
)rofit consciousness is enhanced since managers who are responsible' for profits will constantly
see* ways to increase them. (A manager responsible for mar*eting activities, for e#ample, will
tend to authori&e promotion e#penditures that increase sales, whereas a manager responsible for
profits will be motivated to ma*e promotion e#penditures that increase profits.).
)rofit centers provide top management with ready0made information on the profitability of the
company's individual components. . 5ecause their output is so readily measured, profit centers are
particularly responsive to pressures to improve their competitive performance.
"e!erits:
.
6ivisionali&ation may impose additional costs because of the additional
management, staff personnel, and record *eeping re.uired, and may lead to tas*
redundancies at each profit center.