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Profit Centres
An Organizational unit for which a measures of profit is determined periodically, but one of the features of
profit centre is to encourage decision making initiative.
(2)
A profit centre is a unit for which managers have the authority to take sourcing decisions about the supply
and choice of markets.
It should sell a majority of its output externally and should be free to choose the source of supply for its
goods and services. Even manufacturing or marketing division can be converted into profit centers even
they have limited authority on sourcing decisions.
(3)
When a Responsibility centers financial performance is measured in terms of profit then the centre is called
a profit centre.
management issues
(d) Managers, subjects to fewer have lesser corporate restrictions and are free to use their imaginations and
initiative.
(e) Because profit centers are similar to independent companies, they provide an excellent training ground for
general management. Their managers gain experience in managing all functional areas, and upper
management gains the opportunity to evaluate their potential for higher level jobs.
(f) Profit awareness is improvised since managers responsible for profit will find new ways of increasing it.
(g) Profit centre provide top management with information on the individual profits of business units.
(h) Profit centers are pressured to improve their performance since their profits is readily measured.
Condition Under which Advantages of Profit Center will arise:
(1) Proper system of transfer price: Transfer price should be fair to the buying and selling profit centers
using market price based/ cost price based/ negotiated price mechanism, which wwill affect profit
of the division.
(2) Independence to divisional managers: The business unit managers must have greater authority to
decide on the quality or quantity or both of its output. He may not have complete authority but
he should have the liberty of buying goods internally or externally.
(3) Existence of a market: There must exist, a Reliable & stable market for the goods and services
supplied by one division to another. Identical products or atleast a substitute must be available.
(4) Negotiation: Business unit, managers must freely negotiate & bargain. Buying profit centers try to
minimize & selling profit center try to maximize the Transfer price.
(5) Uniform system of Accounting: there should be a fool proof & uniform system of accounting to
measure the profit. Realistic profit standards should be compared to the company budgeted
profit.
(6) Arbitration: A proper arrangement to settle disputes & resolve conflicts, with the help of an officials
arbitrator must exist.
(7) Organizational Requirements: (a) An organizational chart showing levels of authority &
responsibility. (b) a system of information & reporting like MIS (c) A low employee turnover.
Particulars
Sales
Less: Marginal cost
Contribution
Less: Fixed Cost
Direct profit
Amount
(Rs.000)
500
200
300
100
200
Particulars
Amount (Rs.000)
Sales
Less: Marginal cost
Contribution
Less: Fixed Cost ( Incurred in Profit centre)
Direct profit
Less: Controllable corporate charges
500
200
300
100
200
50
150
30
120
The drawback of this method are that the profit derived under this method cannot be compared with date
published by trade association or with published accounts
(v)
Net
Income:This
technique uses the net income
figure
to
measures
the
profitability of a responsibility
centre. Net income is the surplus
left after deducting all expenses,
allocated corporate overheads,
and income tax from sales
revenue.
Particulars
Amount (Rs.000)
Sales
500
Less: Marginal cost
200
Contribution
300
Less: Fixed Cost ( Incurred in Profit centre)
100
Direct profit
200
Less: Controllable corporate charges
50
Controllable Profit
150
Less: Other allocated corporate overheads
30
Income
Before
Income
Tax
120
Merits:
Less:
Income
tax
@
50%
60
(a) Decisions
related
to
Net
Income
60
installment
sales/hire
purchase, acquisition of fixed assets and disposal of fixed assets are made by profit centre managers. These
decision influence income tax. Consequently this leads to motivation of the manager to minimize income
tax.
(b) The effective rate of income tax is the same among all profit centres.
Demerits:
(a) Corporate headquarters makes many decisions which have income tax implication and the performance of
managers of profit centres should not be affected by such decision.
(b) No advantage arises from the consideration of income tax as income tax as income after tax happens to be
constant percentage of income before tax.
Every SBU is Profit Center but Every Profit Center is Not SBU
Definition of SBU: Most business units are created as profit centers since managers in charge of nsuch unit control
product development, manufacturing & marketing.
These managers can influence revenue and cost and they can be held responsible for the bottom line. A business
unit managers authority may be restricted which is reflected in the design and operation of the profit center.
Examples of profit centers which are not SBU:
(1)
Functional Unit:
Multi-Business companies are divided into different business units, each of which is treated as an independent
profit generating unit but the sub unit of these business units may be functionally organized. The company desires
operation as profit centers but there is no fixed rule to classify business units as profit centers and others.
It is the management decision if a business unit should be a profit centers depending upon the amount of
authority the business unit manager has over the bottom line.
(a) Marketing: Marketing can be turned into profit center by charging it with the cost of goods sold. This
transfer price provides the marketing manager with information required to make optimum,
revenue & cost tradeoff and the standard practice of measuring a profit center manager suing
profitability provides a check by the top management.
The Transfer Price can be the standard cost rather than actual cost.
When marketing managers sxist in different regional areas it is difficult to market, set the price,
advertise, and conduct traning it would be best converted into a profit center.
(b) Manufacturing: Manufacturing is an expenses center & managers are judged on standard v/s actual
cot whose disadvantages are:
Managers may reduce cost of quality control, & transfer goods of infiror quality.
The manufacturing managers will not change his schedule to accommodate an urgent
order.
One of the openion is to change such a Manufacturing unit (SBU) into a profit center & give credit for sales, selling,
but this is imperfect because sales are beyond their control and hence profit will fluctuate.
(2)
Units for maintenance =, IT, Transportation, customer services etc. are all support activities but they can also be
converted into profit centers.
They can charge customers internally & externally for services provided such that revenue is at least equal to
expenses. When service units are organized as profit centers their managers are motivated to control cost to
prevent customers from going elsewhere, while managers of the receiving units are motivated to make decision
about suing the services and paying the price.