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CHAPTER 5
Z UN I BA R OK A H , P H .D .
M A G I S T ER M A N A J EM EN
FA K ULTA S EK ON OM I K A D A N B I S N I S UGM
2 0 1 4
PROFIT CENTERS
GENERAL CONSIDERATION
Divisionalization
Making business unit
Delegating more authority (with certain degree of authority)
Conditions For Delegating Profit Responsibility
Trade-off decisions Involving expense/revenue trade-offs in the
making process.
Conditions before delegating trade-off decision: Manager has
access to relevant information
There are some ways to measure the effectiveness of the
decision
Major step in creating profit centers
Do the advantages of giving profit responsibility offset the
disadvantages?
Prevalence Of Profit Centers
Divisionalization and decentralization developed
after the end of World War II in United States.
Fortunes survey: 93% companies have two or more profit
centers
(of 638 usable responses)
Advantages of Profit Centers (I)
May improve quality of decisions
May increase speed of operating decisions
Headquarters management are relieved of day-to-
day decision making
Managers are freer to use their imagination and
initiative
Advantages of Profit Centers (II)
An excellent training ground for general management
Enhanced profit consciousness
Ready made information of companys components profitability for
top management
Improved competitive performance by responsiveness of profit
centers
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Difficulties with Profit Centers (I)
Loss of control due to decentralized decision making
The quality of decision may be reduced if headquarter
management is more capable or better informed
Friction may increase
May create competition between organizational unit
Difficulties with Profit Centers (II)
May impose additional costs
Competent general managers may not exist
Emphasizing on short-run profitability
Optimizing individual profit centers profit doesnt always equal
optimizing the profits of company as a
whole
BUSINESS UNITS AS PROFIT CENTERS
Most business units are created as profit centers
Constraints on business unit authority
Trade-offs between business unit autonomy and corporate
constraints
Constraints from other business units
The greater the degree of integration, the more difficult it
is
to assign responsibility to a profit center for its
activities
(production, procurement, and marketing decision)
Constraints from Corporate Management
1. Resulting from strategic considerations
Corporate control over new investment: competition
between business units for a share of funds
Business units must refrain from operating beyond its
charter even though they see profit opportunities
Constraints from Corporate Management
2. Resulting because uniformity is required
Business units must conform to corporate accounting and
management control systems
especially troublesome for a new acquired business units
3. Resulting from the economies of centralization
Generally corporate constraints wont cause big problems if they
are dealt with explicitly
OTHER PROFIT CENTERS: Functional Units
Marketing Pre-condition as a profit center: marketing manager is
in the best
position to make principal cost/revenue trade-offs
Could be established by charging activity with the cost of
products sold what would be the best costs? Standard vs actual
Manufacturing Problems in manufacturing as an expense center:
skimp on quality
control, less flexible in accommodating customers needs, lack of
incentive in producing difficult products
Could be established by giving it credit for the selling price
of the products minus estimated marketing price
Pseudo-profit center?
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OTHER PROFIT CENTERS: Functional Units
Service and support units
Could be established by charging the receiving units for
service rendered
Benefit: motivate managers to control costs to maintain
customers loyalty
Example: Singapore Airlines? Swissair?
Other organizations
Ex: branch operation
MEASURING PROFITABILITY
Types of profitability measurement:
A measure of management performance
How well is the manager doing?
A measure of economic performance
How well is the profit center doing as an economic entity?
Types of Profitability Measures
1) Contribution margin
2) Direct profit
3) Controllable profit
4) Income before taxes
5) Net income
Types of Profitability Measures
1) Contribution margin
Revenue variable expenses
Pros:
fixed expenses are beyond managers control
Cons:
almost all fixed costs are either entirely or partially
controllable
by managers
Types of Profitability Measures
2) Direct profit
Revenue all expenses incurred by or directly traceable to the
profit centers (profit centers expenses)
(except expenses incurred at headquarters (HQs))
Weakness: lack of motivational benefit of charging
headquarters costs
Types of Profitability Measures
3) Controllable profit
Revenue profit centers expenses controllable HQs costs
Controllable HQs costs = HQs costs that are controllable by
profit center manager
Weakness:
cannot be compared with other companies profits in the
industry
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Types of Profitability Measures
4) Income before taxes Revenue profit centers expenses allocated
HQs costs
Allocated HQs costs = all HQs costs that are allocated to profit
centers
Cons: Managers are held accountable for costs that are
uncontrollable by
them
Difficulties in properly allocating HQs services
Pros: Keeping head office spending in check (by the questions
from profit
center managers)
Realistic and readily comparable
Managers are motivated to make optimum long-term marketing
decisions
Types of Profitability Measures
5) Net income
Income after taxes
Cons:
No additional advantage in incorporating income after taxes
(income after tax is often a constant percentage of pretax
income)
Not appropriate to judge profit center managers on the
consequences of tax relating decisions that are often made at
HQ
Pros:
Sometimes effective income tax rate does vary among profit
centers, motivating managers to minimize tax
Exhibit 5.3
Profitability Measure
Revenue $ 1000
Cost of sales 600
Variable expenses 180
Contribution margin 220 (1)
Fixed expenses incurred in the profit centers 90
Direct profit 130 (2)
Controllable corporate charges 10
Controllable profit 120 (3)
Other corporate allocations 20
Income before taxes 100 (4)
Taxes 40
Net income $ 60 (5)
Revenue
What is the most appropriate method for revenue
recognition?
Problems: situations in which two or more profit
centers participate in a successful sales effort
Management Considerations
Issues:
Separating the measurement of the manager from the
economic measurement of the profit centers
Degree of managers influence vs real control
Eliminate items that a manager has no influence
