Chapter 5

Profit Centres

Definition of Profit Center Advantages of Profit Centers Condition under which Management is better advice not to create Profit Centers Methods of Measuring Profit of Profit Centers Every SBU is profit center but every Profit Center is not business unit

Definition of Profit Centers

(1) (2) 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. 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. When a Responsibility centers financial performance is measured in terms of profit then the centre is called a profit centre.

(3)

Advantages of Profit Centers

(a) Quality of decision improves because they are being made by managers closest to the point of decision. (b) The Speed of making decision increased since they do not have to be referred to corporate headquarters. (c) Headquarters management, relieved of day-to-day 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: decision making, can concentrate on broader

(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.

Condition (Disadvantages) under which Management is Advice Not to Create Profit Center
(a) Loss of control:Decentralized decision making forces top management to rely more on management control reports, rather than on personal know- how of an operation, which leads to loss of control. (b) Reduction in quality of decision making: If top management is more capable or better informed than the business unit managers, then business units profits may increase. (c) Conflicts:Arguments arise over the TP, allocating of common expenses and credit for revenue granted jointly by business units. (d) Unfair competition: Functional units now compete as business units and an increase in profit for one unit may result in a loss for another. Business unit may not forward sales leads, takeover personnel or equipments and take production decision which increase the cost for other business units. (e) Additional Cost: Divisionalisation imposes additional cost because of staff and record keeping requirement. (f) General management competence: It may not exist in a functional organization due to lack of opportunities to develop management competency. (g) Short term profitability: There may be too much focus on short term profitability instead of long term benefits & high turnover profit centre manager may reduce cost on R & D, training and maintenance. (h) Optimizing companys profits: Individual profit centre profits may not lead to optimum company profit.

Method to Measure Profit of Profit Center

(i) Direct Profit:- Direct profit is the excess of sales value over the marginal cost of sales and fixed cost attributable to the profit centre. The merits of the method are that it is simple, easy to understand, and conceptually sound. However, it has its weakness also. The technique fails to consider the motivation arising from the charging of costs of corporate headquarters. Particulars Sales Less: Marginal cost Contribution Less: Fixed Cost Direct profit Amount (Rs.000) 500 200 300 100 200

(ii) Contribution Margin:- Contribution margin is Particulars Amount arrived at after deducting the marginal cost of sales from (Rs.000) the sales value. It is the excess of sales value over the 500 marginal cost of sales and shows the amount of money Sales 200 contributed by the organizational unit towards the Less: Marginal cost Contribution 300 recovery of fixed cost & generation of profit. The logic underlying this method is that since fixed expenses cannot be controlled by the manager, it is vital that he should aim at ensuring spread between sales value and variable cost. (iii) Income Before Income Tax:- income before tax represents the excess of sales revenue over the cost of sales. It is computed by deducting from the sales value the following expenses: (a) Managerial cost of sales (b) Fixed cost of the profit centre (c) Controllable corporate charges (d) Other controllable allocated Overheads

Particulars Sales Less: Marginal cost Contribution Less: Fixed Cost ( Incurred in Profit centre) Direct profit Less: Controllable corporate charges Less: Other allocated corporate overheads Income Before Income Tax

Amount (Rs.000) 500 200 300 100 200 50 150 30 120

Merits:(a) This act as a motivational tool for responsibility centre manager (b) It reflect as true performance of the entity and facilitate interfirm comparisons. (c) Allocation of corporate overheads helps to keep in check head office expenditure as they would be subject to question by profit centre managers. Demerits:(a) Suitable methods of allocating corporate overheads to profit centre are difficult to find. (b) It is not possible to control the costs incurred by corporate service entities like legal, human resource development, finance & accounts etc. (iv) Controllable Profit: Particulars Amount (Rs.000) Controllable profit is arrived after deducting following items of Sales 500 expenses from the sales revenue: Less: Marginal cost 200 (a) Marginal cost of sales Contribution 300 (b) Fixed cost of the profit Less: Fixed Cost ( Incurred in Profit centre) 100 centre Direct profit 200 (c) Controllable corporate Less: Controllable corporate charges 50 charges Controllable Profit 150 The expenses that are incurred by the corporate headquarter is of two types controllable and non-controllable. The profit centre manager is in the position to control the first category of expenses if not fully to a great extant. The logic underlying this method is that the measurement system should include only those costs that can be influenced by the profit centre manager.

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)

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.

Functional Unit:

(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 managerssxist 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 inferior 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.

There is no incentive or motivation for the manufacturing managers.

(2)

Service & Support Unit:

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.