Chapter 5: Profit Centers

Measuring Profitability - 2 types

1) measurement of management performance 2) economic performance

5 ways to measure the performance of a manager's performance

1. Contribution margin 2. Direct profit 3. Controllable profit 4. Income before taxes 5. NI

Management performance

1. How well manager is doing 2. Used for planning, coordinating, controlling day-to-day activities 3. Device for providing motivation for manager 4. Reported more frequently

Economic performance

1. How well profit center is doing as economic entity 2. Only do when needed 3. Always measured by net income

Advantages of Profit Centers _ of business unit structure

1. Improved quality of decisions (made my managers closes to point of decision) 2. Improved speed of decisions (don't have to refer to HQ) 3. HQ is relieved of day-to-day decision making and can concentrate on broader issues 4. Managers have less constraints and can use their imagination and initiative 5. Training ground for general management (experience managing all functional areas) 6. Profit consciousness (managers who are responsible for profits will constantly seek ways to improve them) 7. Provide top management with ready-made info on the profitability of the company's individual components 8. Improved competitive performance because output is readily measured; responsive to pressures to improve competitiveness

Difficulties with Profit Centers ¬¬_business unit structure

1. Loss of control because of decentralized decision making (top management has to rely on control reports) 2. Quality reduction in decisions made (if HQ is more capable or better informed) 3. Friction may increase because of arguments over appropriate transfer price, assignment of common costs, credit for revenues that were formerly generated jointly _charter 4. Competition between organization units 5. Imposed additional costs because of additional management, personnel, record keeping, etc. required 1. May lead to redundancies 6. (in)Competent general managers may not exist in a functional organization because there may not have been sufficient opportunities for them to develop general management competence 7. Too much emphasis on short-run profitability at expense of long-run profitability 1. Desire to report high current profits (may skimp on RD, training programs, etc.) 8. No completely satisfactory system for ensuring that optimizing the profits of each individual profit center will optimize the profits of the company as a whole

• 2 conditions before delegating trade-off decisions:

1. Manager should have access to the relevant info needed to making an expense/revenue trade-off decision 2. Some way to measure the effectiveness of the trade-off must exist : determine the lowest point in an organization where these 2 conditions exist

1. Constraints from other business units

1. The product decision (what goods/services to make/sell) 2. The marketing decision (how, where and for how much are the goods or services being sold) 3. The procurement/sourcing decision (how to obtain/manufacture) Make v. buy

Constraints from corporate management ...see outline for more!!!!!!!!!!!!

1. Those resulting from strategic operations 2. Those resulting because uniformity is required 3. Those resulting from the economies of centralization

Other Profit Centers

Marketing Manufacturing service and support units Branch operations

pseudo-profit center

profit centers that sell internally to company

Profit Center

when a responsibility center's financial performance is measured in terms of profit Profit is a good measure of performance because it allows management to use one comprehensive indicator rather than several

revenue

when to recognize revenue (when order is made, when an order is shipped, or when cash is received) -what to do when two or more profit centers may participate in a successful sales effort (each center should be given credit for its part in the transaction)

Net Income - 2 argument against it

• After-tax income is often a constant percentage of the pretax income, in which case there would be no advantage in incorporating income taxes 1. There are situations however in which effective income tax rate varies among profit centers a. Foreign subsidiaries • Since many of the decisions that affect income taxes are made at HQ, it is not appropriate to judge profit center managers on the consequences of their actions 0. Some will suggest using EBIT rather than net income because divisional managers do not have control over tax and interest.

Constraints on Business Unit Authority

• Autonomy is not feasible for business unit manager (necessary to realize full benefits of profit center concept) • Business unit structures represent trade-offs between business unit autonomy and corporate constraints o Effectiveness of business unit depends on how well these trade-offs are made

Functional organization

each principal manufacturing or marketing function is performed by a separate organization unit

Key:

include those expenses and revenues in profit center managers' reports that the managers can influence even if they cannot totally control them

Income before taxes

o All corporate OH is allocated to profit centers based on relative amount of expense each profit center incurs

direct profit

o Contribution to general overhead and profit of corporation o Incorporates all expenses either incurred by or directly traceable to the profit center, regardless of whether or not these items are within the profit center manager's control o Expenses incurred at HQ are not included o Weakness: does not recognize the motivational benefit of charging HQ costs

Controllable profit

o HQ expenses can be divided into 2 categories: • Controllable 1. Controllable by BU manager (IT services) 2. Profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager • Noncontrollable o Disadvantage: because it excludes noncontrollable HQ expenses, it cannot be directly compared with either published data or trade association data reporting the profits of other companies in the industry

Contribution Margin

o Spread between revenue and variable expenses o Argument for: FC are beyond control so they should focus on maximizing contribution • Inaccurate; almost all FC are at least partially controllable by manager (discretionary expense items) sales-variable costs

Divisionalization

o When such an organization is converted to one in which each major unit is responsible for both the manufacture and marketing= divisionalization • Divisonalization is about pushing decision making authority down

Income before taxes - 3 arguments for it

• Corporate service units have tendency to increase their power based and enhance their own excellence without regard to their effect on company as a whole 1. Allocating corporate OH costs to profit centers increases likelihood profit center managers will question these costs (parkinson's second law) • Performance of each profit center will become more realistic and more readily comparable to the performance of competitors who pay for similar services • When managers know that their respective centers will not show a profit unless all costs, including the allocated share of corporate overhead are recovered, they are motivated to make optimum long-term marketing decisions as to pricing, product mix, etc. that will benefit the company as a whole

income before taxes- 2 arguments against it

• Since costs incurred by corporate staff departments such as finance, accounting, HR are not controllable by profit center managers, these managers should not be held accountable for them • It may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit center