1. Profit centers Chapter 5

2. Profit Centers What is a profit center? It is a responsibility center whose manager and other employees control both the revenues and the costs of the product or service they sell or deliver. When a responsibility center's financial performance is measured in terms of profit centre is called profit centre. 3. Conditions for delegating profit responsibility To delegate a trade-off decision to a lower level manager, two conditions should exist. Which are as follows: The manager should have access to relevant information needed for making such a decision. There should be some way to measure the effectiveness of the trade-offs the manager has made. 4. Advantages of Profit Center Quality of decisions may improve Speed of operating decisions may be increased Relieved of day to day decision making Profit consciousness Pressure to improve their competitive performance An excellent training ground for general management Managers are free to use their imagination and initiative 5. Disadvantages of Profit Center It will force top management to rely on management control reports rather than personal knowledge entailing some Loss of control Organization units may be in competition with one another Divisionalisation may impose additional cost Competent manager may not exist Too much emphasis on short term profitability at the cost of long run profit No surety that individual profit center will optimize the profit of whole organization 6. Business units as Profit Centers Most business units are created as profit centers since managers in charge of such units typically control product development, manufacturing and marketing resources. 7. Constraints on Business Unit Authority Constraints on Business Unit Authority The Business Unit manager would have to be as autonomous as president of an independent company. Practically such autonomy is not feasible Constraints from other business units It is useful to think of managing a profit center in terms of control over three types of decisions: 1. The product design 2. The marketing decision 3. The procurement or sourcing decision Constraints from corporate management 8. Functional units as Profit Center Multi-business companies are typically divided into business units, each of which is treated as an independent profit generating units. The functional units which can be converted into profit centre are as follows: Marketing Manufacturing Service operations 9. Contd.. Marketing Marketing activity can be turned into profit center by charging it with the cost of the products sold. Manufacturing A manufacturing activity can be turned into a profit center by crediting it for the selling price of the products minus estimated marketing expenses. 10. Contd. Service and support unitsUnits for maintenance, information Technology, transportation, engineering, consulting, customer service, and similar support activities can be made into profit centers. 11. Measuring profitability There are two types of profitability measurements used in evaluating a profit centre. They are: management performance Economic performance 12. Types of Profitability Measures The performance of profit center manager, is evaluated by five different measures of profitability: 1) 2) 3) 4) 5)Contribution margin Direct profit Controllable profit Income before income taxes Net income 13. Proforma of a Profit Centre income statement Revenue xxxx (-)Variable expenses xxx Contribution margin xxx (-)fixed expenses xx Direct profit xxx (-)controllable charges xx Controllable profit xxx (-)other corporate allocations xx Income before taxes xxx (-) taxes xx Net income xx 14. Contd Contribution Margin Contribution margin reflects the spread between revenue and variable expenses. Direct profit This measure reflects a profit centers contribution to the general overhead and profit of the corporation 15. Contd. Controllable profit It includes expenses that are controllable at least to a degree, by the business unit manager. Income before taxes In this measure, all corporate overhead is allocated to profit centers based on the relative amount of expense each profit centre incurs. 16. Contd.. Net income Net income is arrived after the tax is deducted from income before tax.