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Q:2) Every SBU is a profit center but every profit center is not a SBU? What are the conditions that

should be fulfill for an organization unit to be converted into a profit center? What are the different

ays to !easure the perfor!ance of profit center? "iscuss their relevant !erits and de!erits#

$ns:

%ypes of &rofitability 'easures

A profit center's economic performance is always measured by net income (i.e., the income remaining after

all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The

performance of the profit center manager, however, may be evaluated by five different measures of

profitability: (1) contribution margin, () direct profit, (!) controllable profit, (") income before income

ta#es, or ($) net income

() *ontribution 'argin:

%ontribution margin reflects the spread between revenue and variable e#penses. The principal argument in

favor of using it to measure the performance of profit center managers is that since fi#ed e#penses are

beyond their control, managers should focus their attention on ma#imi&ing contribution. The problem withthis argument is that its premises are inaccurate in fact, almost all fi#ed e#penses are at least partially

controllable by the manager, and some are entirely controllable. any e#pense items are discretionary that

is, they can be changed at the discretion of the profit center manager. resumably, senior management

wants the profit center to *eep these discretionary e#penses in line with amounts agreed on in the budget

formulation process. A focus on the contribution margin tends to direct attention away from this

responsibility. +urther, even if an e#pense, such as administrative salaries, cannot be changed in the short

run, the profit center manager is still responsible for controlling employees' efficiency and productivity.

(2) "irect &rofit:

This measure reflects a profit center's contribution to the general overhead and profit of the corporation. t

incorporates all e#penses 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. -#penses incurred at headuarters,

however, are not included in this calculation. A wea*ness of the direct profit measure is that it does not

recogni&e the motivational benefit of charging headuarters costs.

(+) *ontrollable &rofit:

/eaduarters e#penses can be divided into two categories: controllable and non controllable. The former

category includes e#penses that are controllable, at least to a degree, by the business unit manager0

information technology services, for e#ample. f these costs are included in the measurement system, profit

will be what remains after the deduction of all e#penses that may be influenced by the profit center

manager. A maor disadvantage of this measure is that because it e#cludes non controllable headuarters

e#penses it cannot be directly compared with either published data or trade association data reporting the

profits of other companies in the industry.

(,) -nco!e before %a.es:

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n this measure, all corporate overhead is allocated to profit centers based on the relative amount of

e#pense each profit center incurs. There are two arguments against such allocations. +irst, since the costs

incurred by corporate staff departments such as finance, accounting, and human resource management are

not controllable by profit center managers, these managers should not be held accountable for them.

2econd, 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.

There are, however, three arguments in favor of incorporating a portion of corporate overhead into the

profit centers' performance reports. +irst, corporate service units have a tendency to increase their power

base and to enhance their own e#cellence without regard to their effect on the company as a whole.

Allocating corporate overhead costs to profit centers increases the li*elihood that profit center manager3

will uestion these costs, thus serving to *eep head office spending in chec*. (2ome companies have

actually been *nown to sell their corporate ets because of complaints from profit center managers about

the cost of these e#pensive items.) 2econd, the performance of each profit center will become more realisticand more readily comparable to the performance of competitors who pay for similar services. +inally, when

managers *now that their respective centers will not show a profit unless all0costs, including the allocated

share of corporate overhead, are recovered, they are motivated to ma*e optimum long0term mar*eting

decisions as to pricing, product mi#, and so forth, that will ultimately benefit (and even ensure the viability

of) the company as a whole.

f profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the

basis of budgeted, rather than actual, costs, in which case the 4budget4 and 4actual4 columns in the profit

center's performance report will show identical amounts for this particular item. This ensures that profit

center managers will not complain about either the arbitrariness of the allocation or their lac* of control

over these costs, since their performance reports will show no variance in the overhead allocation. nstead,

such variances would appear in the reports of the responsibility center that actually incurred these costs. .

(/) 0et -nco!e:

/ere, companies measure the performance of domestic profit centers according to the bottom line, the

amount of net income after income ta#. There are two principal arguments against using this measure: (1)

after ta# income is often a constant percentage of the preta# income, in which case there would be no

advantage in incorporating income ta#es, and () since many of the decisions that affect income ta#es are

made at headuarters, it is not appropriate to udge profit center managers on the conseuences of these

decisions. There are situations, however, in which the effective income ta# rate does vary among profit

centers. +or e#ample, foreign subsidiaries or business units with foreign operations may have different

effective income ta# rates. n other cases, profit centers may influence income ta#es through their

installment credit policies, their decisions on acuiring or disposing of euipment, and their use of other

generally accepted accounting procedures to distinguish gross income from ta#able income. n these

situations, it may be desirable to allocate income ta# e#penses

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to profit centers not only to measure their economic profitability but also to motivate managers to minimi&e

ta# liability.

'erits:

The uality of decisions may improve because they are being made by managers closest to the

point of decision.

The speed of operating decisions may be increased since they do not have to be referred to

corporate headuarters. . /eaduarters management, relieved of day0to0day decision ma*ing, can

concentrate on broader issues.

anagers, subect to fewer corporate restraints, are freer to use their imagination and

initiative.5ecause profit centers are similar to independent companies, they provide an e#cellent

training ground for general management. Their managers gain e#perience in managing all

functional areas, and upper management gains the opportunity to evaluate their potential for

higher0level obs.

rofit consciousness is enhanced since managers who are responsible' for profits will constantly

see* ways to increase them. (A manager responsible for mar*eting activities, for e#ample, will

tend to authori&e promotion e#penditures that increase sales, whereas a manager responsible for

profits will be motivated to ma*e promotion e#penditures that increase profits.).

rofit centers provide top management with ready0made information on the profitability of the

company's individual components. . 5ecause their output is so readily measured, profit centers are

particularly responsive to pressures to improve their competitive performance.

"e!erits:

.

6ivisionali&ation may impose additional costs because of the additional

management, staff personnel, and record *eeping reuired, and may lead to tas*

redundancies at each profit center.