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. Ex: Singapore Airlines created profit centers such as Singapore Airlines Engineering Company & Singapore Airport Terminal Services (airport services, catering & security).

Service and Supports Units

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. 2.

Contribution Margin

revenue variable expense

Direct Profit

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

3. 4. 5.

Controllable Profit Income before Taxes Net Income

Example of a Profit Center Income Statement

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 Profitability Measure

(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.