05 - Profit Centers

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Chapter 5

PROFIT

CENTERS


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Profit CentersP r o f i t C e n t e r s :

A responsibility centers financialperformance is measured in terms of profit.


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General ConsiderationIn setting up profit center, a companydevolves decision-making power to lower

levels (delegating more authority).

Condition for delegating profit responsibility:1. 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.


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Advantages of Profit Centers

Improve the quality of decisions.Increase the speed of decision-making.Headquarters management, relieved of day-to-day decision making.Managers are freer to use their imagination &initiativesIt is an excellent training ground for general

management.Focus greater attention on profitability.Responsiveness to pressures to improve theircompetitive performance


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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 thecompany as a whole.


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Business Units as Profit Centers

Most business units are created as profitcenters. Why?

Constraints on business unit authority:Constraints from other business units.Greater degree of integration within a company, themore difficult it become to assign responsible to a singleprofit 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.


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Other Profit Centers

Functional UnitsBased on the amount of influence (even if not totalcontrol) the units manager exercises over the activitiesthat effect the bottom line.

MarketingCharging the marketing dept with the cost of theproduct sold.

transfer price standard cost

When should a marketing activity be given profitresponsibility?When the marketing manager is in best position tomake the principal cost/revenue trade-offs.


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ManufacturingMust be under appropriate circumstances orconsideration.

Some authors maintain that manufacturing units shouldnot be made into profit centers unless they sales a largeportion of their output to outside customers.

Service and Supports UnitsEx: Singapore Airlines created profit centers such asSingapore Airlines Engineering Company & SingaporeAirport Terminal Services (airport services, catering &security).

Other Profit Centers


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Measuring ProfitabilityTwo types of profitabilitymeasurements used inevaluating a profit centers:

1. The measure of management performance , which focuses onhow well the manager doing.

2. The measure of economic performance, which focuses onhow well the profit center is doingas an economic entity.


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Types of Profitability Measures

1. Contribution Marginrevenue variable expense

2. Direct ProfitProfit centers contribution to the generaloverhead & profit of the corporation.

3. Controllable Profit4. Income before Taxes5. Net Income


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Example of a Profit CenterIncome Statement

Revenue $ 1,000 Cost of sales 600 Variable expenses..180

Contribution margin 220 (1)Fixed expenses incurred in the profit center 90

Direct profit 130 (2)Controllable corporate charges.10

Controllable profit

120 (3)Other corporate allocations20Income before taxes 100 (4)

Taxes..40Net Income 60 (5)

Profitability Measure


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RevenuesChoosing the appropriate revenue recognitionmethod.

Management ConsiderationsManagers should be measured against thoseitems they can influence, even if they do nothave total control over those items.

Ex: managers should be measured on an aftertaxbasis only if they can influence the amount of taxtheir unit pays

Items that are clearly cannot influence, such ascurrency fluctuation, should be eliminated.

05 - Profit Centers

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