methods to measure a profit center / messages type of measure convey to managers

When financial performance in a responsibility center is measured in terms of profit, which is the difference between the revenues and expenses, the responsibility center is called a profit center.Profit as a measure of performance is especially useful since it enables senior management to use one comprehensive measure instead of several measures that often point to different directions.

There are two types of profitability measurements in a profit center, just as there are for the organization as a whole. There is, first, a measure of management performance, in which the focus is on how well the manager is doing. This measure is used for planning, coordinating and controlling the day-to-day activities of the profit center. Second, there is a measure of economic performance, in which the focus is on how well the profit center is doing as an economic entity. The message given by these two measures may be quite different.

Ø Types of Profitability measures:

In order to evaluate the economic performance of a profit center, one must use net income after allocating all costs. However, in evaluating the performance of manager, any of five different measures of profitability can be used.

1) Contribution Margin: The logic behind using contribution margin as a measure is that fixed expenses are not controllable by the manager, and therefore he should focus on maximizing the spread between revenue and expenses. But the problem with this is that some fixed costs are controllable and all fixed costs are partially controllable. A focus on the contribution margin tends to direct attention away from this responsibility.

2) Direct Profit: This measure shows the amount that the profit center contributes to the general overhead and profit of the corporation. It incorporates all expenses incurred in or directly traced to the profit center, regardless of whether these items are entirely controllable by the profit center manager. A weakness of this measure is that it does not recognize the motivational benefit of charging headquarters costs.

3) Controllable Profit: Headquarters expenses are divided into two categories: controllable and non-controllable. The controllable expenses are controlled by business unit manager. Consequently, if these costs are included in the management system, the profit will be after the deduction of all expenses that are influenced by profit center manager.

4) Income before Taxes: In this measure, all corporate overhead is allocated to profit centers. The basis of allocation reflects the relative amount of expense that is incurred for each profit center. If corporate overheads are allocated to profit centers, budgeted costs, not actual costs, should be allocated. Then the performance report will show an identical amount in the “budget” and “actual” columns for such overheads.

5) Net Income: Here, companies measure performance of domestic profit centers at the bottom line, the amount of net income after income tax. There are two arguments 1) Income after tax is constant percentage of the pretax income, so there is no advantage in incorporating income taxes 2) many decisions that have impact on income taxes are made at headquarters, and it is believed that profit center manager should not be judged by the consequences of these decisions.