A profit center is defined as an integral part of a business entity that makes identifiable contributions towards the organization’s coffers. It is a separate unit inside the company that is treated as a separate business and is also expected to earn its keep by creating sales and generating revenues
Meaning of profit center
A profit center contributes towards the overall finances of an organization. It has the responsibility to target a certain revenue figure and is given the authority to control the costs to fulfill those targets.
The profit and loss are calculated on a separate basis to determine and measure their worthiness and profitability.
The profit center is headed by a manager, who is accountable for creating activities that can generate sales which will lead to cash inflows and for controlling activities that will increase costs.
He faces considerable pressure as it is his responsibility to ensure the services or sales outweighs the cost and creates good profit margins.
Some examples of profit centers are individual restaurants in a large chain of restaurants, individual retail outlets that are a part of the larger retail chain, consulting organization, and sales organization.
It is a crucial unit of a company that can help the business to determine which one is the most profitable. It can facilitate an accurate analysis of divisions so that cross-comparisons becomes easier.
This analysis is used while allocating resources in the future and deciding which activities are unnecessary for the business.
Real-Life examples of profit center
Microsoft is a world-renowned company that has several profit centers in its organization; for instance, digital service, software, and hardware.
It analyses them to know about the profitability of each department separately so that it can have a detailed idea of the associated costs and generated revenues and compare every one of them.
Walmart is a retailer that has created different departments as a profit center to work independently from each other. For example, home products and clothing are two of their profit center. The organization has also set up year-around and seasonal profit centers as per the product sales of a product.
13. Advantages of profit center
The advantages are as follows-
- It is focussed on generating revenues and gives insight about how and where it is earned
- It offers a closer look inside a complex business entity via individual departments or units.
- Sets objectives for earning profits and supports measures to control the budget at a different level
- A profit center in itself is a separate unit and is thus motivated to work better to show that it is a profitable department of the organization
- It is easy to make comparisons between profit centers of a similar nature to identify the areas of concern and work accordingly to improve yours
- The profit center helps the manager to become responsible. It improves his decision making powers as he will need to make independent decisions for his unit.
- The operating decisions are now quick and prompt as the manager does not have to wait for the confirmation from top-level management.
- The quality o the decisions also improves as the manager is aware that it will have a direct impact on his unit for which he alone is responsible and accountable
- The top-level management is now free to put its onus on macro issues as the micro ones are handled efficiently by operational managers of the profit centers
- Managers are free from outward influence and can give free rein to its creativity and innovation
- The allocation of resources is more efficient because of the analysis made by a profit center.
- Is considered a training ground for business managers of higher levels
- A wider pool of managerial resources is created that the company can utilize as per its needs and requirements.
9. Disadvantages of profit center
The disadvantages are as follows-
- Setting up a profit center is an expensive work as the company has to spend extra money on the manager, staff, and other resources needed for its daily operations and maintenance.
- Top management loses a part of its controlling power. The center is now the jurisdiction of its manager who prepares the report and submits it to the top management, who in reality, does not have any intricate knowledge about its daily operations.
- The appointed manager might be incompetent and lacking in appropriate skills to take the company forward.
- There can develop unhealthy competition amongst the different profit centers and can result in unreasonable behavior from the managers. It can lead to hoarding of equipment and hiding of valuable information.
- Sometimes it start pursuing their own goals instead of the vision and directive of its organization.
- Disagreements often arise amongst the different centers regarding sharing of revenues, sharing of costs, prices, and transfers generated by the efforts of both the centers jointly.
- They put their onus on short-term benefits instead of long-term advantages. It can be at the expense of other activities like research and development, training, and maintenance.
- High profits of a profit center do not always signify greater revenues for the company as a whole
- It is a time-consuming venture to set up a separate entity and monitor it regularly.
Types of profitability measure
There are two types of profitability measurement tool in a profit center. The first is a measure of management performance where the focus is on evaluating the working of the manager and is also used for controlling, coordinating, and planning the daily activities of the profit center.
The second is a measure of economic performance where the onus is on how good the profit center is performing as an economic activity. It is possible to measure the performance of a manager via any of these profitability measures-
1. Direct Profit
It is a measure that shows the sum that is contributed towards the profit and general overhead of a company by a profit center. It includes all expenses that can be tracked to the profit center.
2. Contribution Margin
The manager should put its onus in increasing the difference between revenue and expenses. All the fixed costs are partially controllable, and only some of them can be fully controlled. The manager can not control it, and the contribution margin directs the attention away from this responsibility.
3. Income before Taxes
In this type of measure, the corporate overhead is billed to the profit center. The basis for such a move is a reflection of the amount of expense that occurs for each profit center.
4. Controllable Profit
The controllable expenses under the heading headquarters expense are controlled by the unit manager. If any such costs occur and are included in the management system, the profit is declared after deducting like-minded expenses influenced by the manager of a profit center.
5. Net Income
In this type, the organization measures the performance of a profit center at the bottom line as the amount of net income after calculating the income tax.
How to measure the performance of a profit center?
Five ways can help you to measure the performance of a profit center. These are described below-
- It creates a budget for revenue and cost. When a comparison is made between both of them, you can get a direct measure of the performance of a profit center
- It becomes easy to look at the profit figures and divide it by the units sold to know how much profit is generated for every unit. This will help you to measure its performance
- When the gross profit is divided by sales, you can get a gross profit percentage, and this will help you to measure its performance
- When you divide the net profit by sales, you can get an estimate about net profit percentage to measure the performance successfully.
- As the profit center has direct access to its actual sales and expense figures, it can find out the ration between expenses and sales to measure profitability and performance.