When financial performance of a responsibility center is measured in terms of the organization’s profit, then it is called a profit center. In a profit center, performance is measured in terms of the numerical difference between revenues (outputs) and expenditure (inputs). A profit center is given the responsibility of earning profits. It is involved in the manufacture and sale of outputs, and it measures how well the center is doing economically. The profit center also determines the efficiency of the manager in charge of the center. Profit as a measure of performance is especially useful since it enables senior management to use one comprehensive measure instead of several measures that often point to different directions. A profit center helps in motivating managers to perform well in areas they control and also encourages managers to take initiatives. The profit center helps the organization to make the best use of specialized market knowledge of the divisional managers, and entrusts the local managers the responsibility of tradeoffs.
A typical example of a profit center is a division of the company that produces and markets different products. The manager of this division will be responsible for the setting up of production policies and the price as also marketing strategies. Even though the division manager may propose the investments in the division the decisions are usually made by the top management.
Profit centers have been used as a major management control tool. The major advantages of profit centers are:
- These help in increasing the speed of making operating decisions as they do not have to be referred to corporate headquarters.
- As the decision-making authority lies with the managers they can make better decisions related to the task they are performing, because they can understand the nature of the work better.
- Since profit centers make their day-to-day decisions themselves headquarters can concentrate on broader issues of the organization.
- Managers are motivated to perform more effectively, as they are responsible for increasing the profit of their unit.
- Managers use their imagination, take initiatives to perform more effectively, to increase the profit of their unit.
However, there are certain difficulties associated with the creation of profit centers. The management cannot have considerable control over the different profit centers when decisions are centralized. The top management has to depend on management control reports which may not be as effective as the personal knowledge of an operation. There may be no place for competent general managers in a functional organization because of lack of opportunities for them to develop creative management skills.
Organizational units compete with one another, and this may, sometimes, result in conflict between different centers and reduction in cooperation between different units and sharing of resources.
Types of Profit Centers
Functional units can be classified as different types of profit centers. A multi business company can be divided into independent profit generating units such as marketing, finance, manufacturing etc. The decisions regarding whether a particular functional unit can be a profit center depends on the responsibility center manager’s ability to influence, if not control, other activities that affect the company’s bottom line. The different types of profit centers are discussed below:
- Marketing: A marketing activity becomes a profit center if it is charged with the cost of the products sold. A marketing activity can be given the responsibility of making profit when the marketing manager has the authority to make principal cost/revenue trade off in terms of marketing a product, spending on sales promotion, the appropriate time for this expenditure and on which media to spend.
- Manufacturing: This is an expense center and the management of activities here is based on performance against standard costs and overhead budgets. Problems in measurement may occur because of inadequate quality control, shipping of inferior quality products, and so on, to obtain standard cost credit. At times, there may arise the need to accommodate an order in-between production schedules, and the manufacturing managers may be reluctant to interrupt these schedules. In manufacturing units, when performance is measured against standards, there may be no incentives for manufacturing products that are difficult to produce. These factors may demotivate the managers, and eventually, they may not try to improve standards. Hence, while measuring the performance of manufacturing activities against standard costs, it is important to take into consideration quality control, production scheduling and the make or buy decisions.
Measuring Profitability of Profit Centers
Profitability measurements in a profit center can be of two types – management performance and economic performance. Management performance focuses on the manager’s performance while economic performance relates to how well a profit center is performing as an economic entity. Management performance is a measure used for planning, controlling and coordinating the day-to-day activities of the profit center. The performance measures of profit centers can be different and hence, the necessary purpose for the information should not be obtained from a single set of data. For example, the management performance report can show excellent performance of a profit center manager. But the economic and competitive forces for that particular report can show poor economic performance. As a result, the center may run into losses and may even have to close shop.
- Contribution margin: This performance measure is used on the premise that, since fixed expenses are not controllable by the manager, the focus should rest on maximizing the difference between revenues and variable expenses. The problems of using contribution margin is that since many of the center’s expenses may vary according to the discretion of the profit center manager, focus on the contribution margin tends to direct the attention of the profit center manager away from the goals of the center.
- Direct profit: This measure helps in understanding the contribution of the profit center to the general overhead profit of the corporation. It encompasses all the expenses directly incurred by profit centers or related to profit centers, irrespective of whether the expenses are controllable by the profit center manager. However, it does not include corporate expenses.
- Controllable profit: The headquarters expenses in an organization can be divided into two categories-controllable and uncontrollable. Controllable expenses include expenses that are controlled by the business unit manager. The advantage of including such costs in the measurement system is that the profit will be calculated after the deduction of expenses that can be influenced by the profit center manager. Hence, these are controllable profits. As uncontrollable headquarters expenses are taken into consideration while calculating controllable profits, controllable profits cannot be compared directly with published data or with trade association data, which report the profits of other companies in the industry.
- Net income: The performance is measured by taking into consideration the net income after the payment of taxes. The disadvantage of using this method is that many decisions that have an impact on the income taxes are made at headquarters, and profit center managers should not be judged by these decisions. If the income after tax payment is constant percentage of the income before tax payment, then there would be no need to measure performance based on this method. This method would be useful if profit centers influence decisions like installing credit policies or disposing of equipment. This method is also useful to motivate the manager to minimize taxes in case the taxable income differs from income, as measured by using generally accepted accounting principles. The performance of profit centers can be measured by comparing actual results with one or more of the measures discussed above with budgeted amounts. In addition, data on competitors and industry provide a good crosscheck on the appropriateness of the budget.