Everything you need to know about profit centers [explained by a Certified Accountant]
Profit center represents a self-contained “entity within an entity” that operates practically independently, producing its own costs, revenues and profit/loss.
Profit centers are used for the purposes of financial planning, control, comparison and performance management across subunits in a decentralized organization.
The term “profit center” was coined by Peter Drucker back in year 1945.
The 10 key characteristics of a profit center:
Standalone “company within a company”, equivalent to an independent business within the context of a larger organization.
Business unit responsible for revenue generation in an organization, driving sales activities that lead to cash inflows and eventually profits for the parent entity.
Primary goal is to maximize the unit’s net income and the company’s overall bottom line.
Management was delegated with the decision-making authority over both the revenues generated and the costs incurred by the unit in the course of business operations.
Management is held accountable for profits and so needs to balance the costs and revenues of the unit by increasing revenue and decreasing expenses.
Management is motivated to optimize profitability because it directly controls the outcomes and is rewarded based on performance.
Distinct reporting segment in an organization with its own separate set of financial and management accounts, integrated into the accounting system of the parent entity.
Used for the purposes of financial planning and control in a decentralized company.
Any financial performance metric can be calculated for each center individually (e.g., financial ratios, profit margins, ROI) as profit centers generate revenues independently from other units.
One type of a responsibility center, along with a cost center, revenue center and investment center.
There are two types of profit centers:
Internal division or department that operates independently with responsibility for its own costs and revenue, such as a sales department.
Organizational unit for which profitability is analyzed separately, such as a product or location.
Profit center examples:
For a real-life example, let’s take a look at the operating segments reported in the 10-K annual report filings for the SEC (U.S. Securities and Exchange Commission) of two major S&P 500 corporations – Johnson & Johnson and Microsoft.
If the companies are using the profit center approach for their internal accounting purposes, it can be reasonably assumed that these segments serve as their main profit centers.
Johnson & Johnson in their 10-K SEC annual report filing state that the company is organized into 3 business segments and 4 geographic areas:
1. Consumer: Broad range of products used in the following markets: baby care (e.g., Johnson’s), oral care (e.g., Listerine), beauty. (e.g. Neutrogena), over-the-counter pharmaceutical (e.g., Tylenol), women’s health (e.g., Carefree), wound care (e.g., Band-Aid).
2. Pharmaceutical: Six therapeutic areas: Immunology (e.g., rheumatoid arthritis), Infectious Diseases and Vaccines (e.g., HIV/AIDS), Neuroscience (e.g., mood disorders), Oncology (e.g., hematologic malignancies), Cardiovascular and Metabolism (e.g., diabetes) and Pulmonary Hypertension.
3. Medical Devices: Broad range of products used in Diabetes Care, Diagnostics, Interventional Solutions, Orthopaedics, Surgery and Vision.
1. United States
3. Western Hemisphere, excluding U.S.
4. Africa, Asia and Pacific
Microsoft’s SEC 10-K annual filing reports that their financial performance is based on the following 3 segments:
Identifying profit centers within an organization enables:
For example, you can calculate the key performance metrics and financial indicators (e.g., profit margins, profitability ratios, cash flows) for each profit center separately and then compare them against other business units.
Profit centers help to maximize the profitability of an organization by facilitating optimal resource allocation and effective strategic decision making.
For instance, management may direct more funds into profit centers that generate the most profit, while attempting to improve performance of units that are less profitable, and eliminating any loss-making business segments.
In other words, do more of what works and less of what doesn’t.
Profit centers also serve as an internal control tool that supports the management of the autonomous business units which have been delegated responsibility over their own costs and revenues.
As an example, each profit center has its own budget and regular analysis of variances between the budgeted and actual figures help in effective budgetary control.
Profit centers provide motivation to optimize profitability and promote behavioral congruence across the entire organization because the management and teams of each center are:
The top 5 issues associated with profit centers are:
1. Incentivizing undesirable priorities, such as short-term profit maximization instead of long-term health of a company.
2. Excessive focus on cutting costs rather than reinvesting funds into future business growth.
3. Decisions taken for the benefit of one profit center may not be in the best interest of the business as a whole.
4. Allocation of resources, such as direct and indirect costs, to profit centers can be higly complex and inaccurate.
5. Unhealthy competition and rivalry may be encouraged within the organizational units.
In fact, Peter Drucker who coined the term “profit center” back in year 1945 later stated that it was a mistake and that there only cost centers in business, no profit centers–other than a “customer’s check that hasn’t bounced”.
Internally, a profit center is typically accounted for like an independent company within a company, conducting business separately and preparing its own financial accounts, budget, forecast and other management reports.
Such separation in the internal accounting system allows management to easily ascertain how well each profit center is doing and compare performance and profitability between business units.
However, for external reporting purposes, all profit centers are consolidated into the parent entity’s financial statements because they are all in fact part of the same business.
Some entities, especially those publicly held, may disclose information regarding operating segments in the notes accompanying their financial statements–voluntarily or on a mandatory basis in order to comply with financial reporting standards like IFRS 8 “Operating Segments” or FASB Statement no. 131 “Disclosures about Segments of an Enterprise and Related Information”.
Profit center is one of four types of responsibility centers, which are organizational units responsible for certain financial and non-financial performance measures within a business.
|Responsibility Centers: Profit vs. Cost vs. Revenue vs. Investment
|Business Performance Measure
|ROI, ROA, ROCE*
|* Return on Investment, Return on Assets, Return on Capital Employed
The difference between a profit center and a cost center is that a cost center is an organizational subunit that is only responsible for its costs, whereas a profit center is accountable for both the expenses it incurs and the revenues it generates, as well as the overall resulting profit or loss.
The difference between a profit center and a revenue center is that a revenue center is a business unit that is only evaluated based on the revenues it generates, whereas a profit center is responsible for both its revenues as well as the costs it incurs during business operations, and the resulting profit or loss.
The difference between a profit center and an investment center is that a profit center is evaluated based on the profit contribution the business unit made to the parent entity’s bottom line, whereas investment center is judged on the return on investment in terms of assets and capital employed.
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