integrate the concept of profit centers and the organization structure of an organization;

Transcription

1 UNIT5 PROFIT CENTRES Profit Centres Objectives After you have studied this unit, you should be able to: understand the concept of profit centers; integrate the concept of profit centers and the organization structure of an organization; identify the important factors to be considered in the establishment of a profit center; and understand and apply the basic requirement of a system of performance evaluation of a profit center. 5.1 Introduction 5.2 The Role of Profit Centres in an Organization Advantages of Profit Centre Difficulties with Profit Centre 5.3 Boundary Conditions for Profit Centres 5.4 Performance Measurement of Profit Centres 5.5 Profit Centre as a Motivational Tool 5.6 Performance Related Compensation 5.7 Summary 5.8 Key Words 5.9 Self Assessment Questions 5.10 Further Readings 5.1 INTRODUCTION A Profit Centre is a segment of a business, often called division that is responsible for both revenue and expenses. In a non-profit organization, the term `revenue centre' may be used instead of profit centre' as profit may not be the primary objective-of such an organization. In other words, a profit centre is a responsibility centre in which inputs are measured in terms of expenses and outputs are measured in terms of revenues. The expense centre, expense responsibility centre and profit centre are inter-related. The main objective of expense centre is to effect expense control. In case of profit centre, expense control is only one of the several considerations. The scope of a profit centre is broader than that of expense centre. In a profit centre the measures of performance is boarder than that of an expense centre as in expense centre, we measure only one element, i.e., cost whereas in profit centre we measure both cost as well as revenue. Similarly, the scope of activities of profit centre is much broader than that of revenue centre because of the responsibility to produce the product more efficiently. In a profit centre, manager has the responsibility air' authority to make decisions that affect both costs and revenues for the department or division. In fact, the main objective of a profit centre is to earn profit. Thus, a profit centre manager aims at 21

2 Management Control both the production and marketing of a product. Such a manager decides about the production policies, the price and marketing strategies. He is concerned with increasing the centre's revenues by increasing production and/or improving distribution methods. However, such a manager does not take decision or has control over the investment in the centre's assets. He may make proposals for the investment in the division but the decisions about it are normally taken by the top management. A typical example of a profit centre is a division of the company that produces and undertakes marketing of different products. Thus, it is concerned both with formation of production strategy as well as marketing strategy. The main objective being to earn higher profits by pursuing such policies. Financial performance of a profit centre manager is measured in terms of achievement of budgeted profits that way, a comparison has to be done between the profit centre and budgeted profit. However, a problem arises in measuring its performance in terms of profits, when products and services are provided to another unit within the organization. Determination of profit is easier when products and services are sold outside the organizations. For example, repairs and maintenance department in a company can be treated as a profit centre if it is allowed to bill other production departments for the services provided to them, 5.2 THE ROLE OF PROFIT CENTRES IN AN ORGANIZATION In most of the organizations, it is found that there is more concentration on profit centre as an important unit for the purpose of control. In case of profit centre, it is possible to have an effective system of evaluation of performance which is quite necessary to impose effective control. Such effective control, from this point, is not possible neither in case of expense centre nor revenue centre. The profit centre focuses its attention on the most crucial element of an organization, i.e., profit. The profit is a combined measure of both effectiveness and efficiency. It provides a powerful tool for measuring how well the profit centre and its manager has performed. It motivates the profit centre manager to take decision about inputs and outputs in such a way that the profit of a profit centre is maximized. The profit centre becomes a good training ground for general management responsibility. It enables the top management to focus its attention and give advice to those segments which require them the moss. It also gives a sense of satisfaction to the manager concerned as the result is directly linked to the activities. The profit centre used as a means of basing the compensation structure. The profit centre is also closely related to the organizational principle of decentralisation Advantages of Profit Centres The operating decisions can be taken quickly without refering to the headquarters. Quality of the decisions is improved because the managers taking these decisions are aware of the ground realities and also closest to the point of decision. Higher management can focus on macro issues leaving the micro issues to be tackled by operational managers. 22 Profit consciousness is enhanced in profit centre managers due to the fact that profit is going to be the criteria for assesment and as a result the managers would be sensitive to the impact of their action on both the expenses and revenue.

3 Managers are free of micro restraints and can use their creativity and initiative. Profit Centres Profit centres are incubators for future business managers at higher level as they are excellent training ground for general management. Profit centres creates a reservior of managerial talent which a company can use during diversification. Use of profit centres helps the company to locate and diagnose the problem areas quite easily, because profit centres provide information on the profitability of the components of the company Difficulties with Profit Centres Top management may loose some control as the control reports prepared by the profit centres are not as effective as personal knowledge of an operation. Managers may be lacking competence in general management operations. There may be unhealthy competition among the various profit centres, which may manifest itself in form of undesirable behaviour of managers. These type of undesirable behaviour may include, hiding of information, hoarding of equipment etc. There may be disagreement among different profit centres regarding transfer, price, sharing of common cost, sharing of revenues generated by joint efforts. Profit centre managers may lay emphasis on short term profits at the expense of long term profits by neglecting crucial area like manpower training and development, maintenance and research and development activities. High profits of the profit centre may not always optimize the profits of the company. Setting up of profit centres may entail extra cost to the company in the form of additional management, staff and record keeping and additional ancillary infrastructure which may lead to redundant tasks at each profit centre. Activity 1 Try to define a profit centre? In what way a profit centre is different from an expense centre? 5.3 BOUNDARY CONDITIONS FOR PROFIT CENTRES In companies where each of the principal function of manufacturing and marketing is performed by seperate organizational units, these type of compnies (organizations) are known as functional organizations.as the companies expand and mature over a period of time offering diverse products and services, it becomes difficult for top management to pay equal attention to all products and services. In this scenario one of the option available is to divisionalize the company which implies that each major organizational unit in the company is responsible for both the manufactu r ing and the marketing of the product, implication of this move is that there is greater amount of delegation of authority and responsibility to the operating managers. An organization with several divisions is a complex as a whole. Tile divisions, however, are not separate entities in their own right. The design of profit centres in 23

4 Management Control organizations will have to contend with the question of service functions centrally located in the headquarter which do not directly contribute towards performance of profit centres. We also have to consider the domain of the profit centre. Thus, defining the boundary conditions for the profit centres is an important aspect of the design of profit centres. The major problem associated with the service functions is that there is no direct measures of profit which can satisfactorily evaluate the performance of the function. Even though the service functions are very important in the profit performance of the company as a whole, it is very difficult to isolate and measure their contribution. It may be possible to organize many service centres into profit centres and their services could be sold, but in most organizations they are intended to provide their services only to the organization. Their services may not be used in sufficiently large volume if they are organized as profit centres. The examples of service functions are management information service, legal services, corporate planning department etc. A plausible solution is to distribute the cost of service functions among various profit centre where such activity can be economically justified. The major problem is to define the boundary conditions for the profit centre where by we can balance the costs and revenues of the division. The major objective of the exercise is to ensure that we maximize certain revenues and minimize certain costs. Therefore, measurement of profits as the outcome becomes the major criteria in decision making within the division. This leads us to the most logical choice of accepting profit performance measurement as the major factor guiding the determination of profit boundaries. However, we should not lose sight of the fact that what is good performance of the division need not always be the good performance of the company as a whole. Further, the profit centres should not result in conflict with other divisions within the organization. These conflicts to occur in organizations when the divisional managers in their eagerness to achieves profit in their division lose track of the interest of other divisions. Appropriate boundaries for profit centres thus would ensure a more meaningful profit performance of the profit centre managers and act as better incentive. Economic basis of the profit centre boundary revolves around factors such as market for the product, cost and revenues structure and the separability of their cost and revenues from the rest of the organization, management objectives and above all the extent of operational freedom that is available. Access to the market is very important with respect to profit centre performance in that the choice of market, adaptation of the product to market are necessary for maximization of revenues. Cost and revenues are separate from the rest of the organization and the ability to influence them by the decisions of the division is a necessary condition for influencing profit. A manager should be evaluated only on the basis of items over which he has control. If most costs and revenues are not separable and controllable part of this is too small, profit centre may not be of much use. Management must be willing to accept the profit performance of the division and be prepared to guide the decisions of the profit centres without curtailing their freedom. It should be borne in mind that profit alone could never be the sole criteria for evaluation of the performance of a profit centre. 24 All aspects considered, however, rightly demarcated boundaries of profit centres will not produce any tangible to the organizational unless the divisions have a reasonable measure of operational autonomy. The autonomy will have to be clearly understood within the context of overall rules of the game established by the top management.

5 Autonomy is crucial in decision areas such as buying, production and its scheduling; inventory policies, choice of market, product mix and pricing Profit Centres Activity 2 1) Try to prepare a check list of the boundary conditions for the establishment of profit centres in an organization. 2) List down the organization requirements for the establishment of profit centres. 5.4 PERFORMANCE MEASUREMENT OF PROFIT CENTRES Having demarcated the boundaries for profit centres; it becomes important and necessary to measure their performance. However, with boundaries so set, performance measurement becomes easier and convenient. But still the measurement of profit is not a simple task. It poses problem as the concept of profit may not be very clear, the problem of transfer pricing has to be tackled and the decision has to be taken regarding compensation based on evaluation. Basic of Measurement of Performance It is not quite easy or simple to decide the basis of measurement of performance. However, the profit contribution by the profit centre may be taken as basis for it. However, if current profit is taken as the basis it may be in tune with goals of the organization which may be short-term as well as long-term. In fact, the short term profit goals may be in consonance with the long-term profit goals. In this connection, one problem arises regarding question of current profitability as compared to future growth. If we confine to current profit only, it would be at the cost of future growth.' Similarly, the concern for future growth can be achieved at the expense of the current profit performance. Another problem may arise when we devote our attention to R&D. Any additional cost incurrent for R&D would certainty affect the current profit performance. Similarly, the cost for current training and development which is quite necessary for the development of the organization ultimately has the adverse impact on current profit performance. The Concept of Profit There are different concepts used related to profit, hence, that would also pose a problem in this connection. This term may have different connotations, such as book profit, real profit, and profit contribution. The easiest and most acceptable concept of profit is the book profit, which is shown by the books of account. However, when we take into account the book profit, the problem of allocation of organizational expenses arises. It is not easy to solve it as no method of such allocation seems to be scientific one and that may be questionable. The real profit may be a better basis of evaluation of performance, as the real profit takes into account economic value of the resources consumed. For this, valuation of resources consumed should be taken, taking into account depreciation. In this case, also the question of allocation of common expenses remains untackled. 25

6 Management Control This leads to choosing the third concept of profit, i.e., the profit contribution. It implies profit contributed directly by the division. It may also be described as `incremental profit' or the `additional profit' earned solely as a result of operations of the division. The Question of Expression of Profit Another related problem is how do we express the profit in the context of profit centres. Is it to be expressed as an absolute amount? Or as a margin on sales? Or as a rate of return on investment? Whichever way express profit, it has its own significance. And all the questions relating to measurement of profit will be applicable in whatever way we express profit.. Transfer Price and Profit Centres The measurement of profit in a profit centre is also complicated by the problem of transfer prices. A transfer price is a price used to measure the value of goods/ services furnished by a profit centre to other responsibility centres within a company. In other words, when internal exchange of goods and services takes place between the different divisions of the firm that requires their valuation in terms of money. It becomes quite necessary to deal with transfer price as the profit centres as buyers and sellers should be able to negotiate prices of such transfer independently. Activity 3 1) What difficulties are to be sorted out before designing an evaluation system for profit centres? 2) Can you try to enumerate the problems associated with profit' and its measurement for a division?.... Problem of Analysis of Profit Centre Results 26 Apart from the profit measurement and associated problems, there is also the problem of understanding the performance itself. Usually profit performance problem of understanding the performance itself. Usually profit centre performance will have to be evaluated against some standards and the most common practice is to evaluate the same against the budgets. The variances occur as a result of the combined influence of a host of factors. Unless these influences can be segregated and understood the major objective of control would not be achieved. Further, reliance on the total deviation without isolating the controllable and non-controllable aspects of the variations may have demotivating impact on the managers.

7 The problem will also be different when the division is a single product or a multi product division. However, in the case of a multi-product division the problem may be more complex. Profit Centres We shall try to analyse the variances of net income before tax for profit centre. We use the data of Ibid Apparel presented in Table 5.1 and 5.2 for this purpose. For the sake of simplicity, we have grouped the products into major groups and we will use the average data for each group as the per unit information Table 5.1 : Ibis Apparels Master Budget Sales and Expense Data for Period 1 (in 000) Products Undergarments Outergarments Master Per Unit Total Per Unit Total Budget Sales in Units 7,000 8,000 15,000 Sales Revenue Rs Rs.70,000 Rs Rs.3,20,000 Rs.3,90,000 Variable expenses Manufacturing 4,00 28, ,20,000 1,48,000 Marketing , ,000 78,000 Total Variable expenses Rs.6.00 Rs.42,000 Rs Rs.1,84,000 Rs.2,26,00 Contribution margin Rs.4.00 Rs Rs. 17,00 Rs.I,36,000 Rs.1,64,00 Fixed expenses Manufacturing Rs.60,000 Marketing Rs.75,000 Administration 14,000 Total Rs. 1,49,000 Net profit before taxes 15,000 Table 5.2: Ibis Apparels Actual Sales and Expense Data for Period 1 Products Undergarments Outer-garments Actual Per Unit Total Per Unit Total Total Sales in Units ,000 15,000 Sales Revenue Rs.9.00 Rs.90,000 Rs Rs.2,50,000 Rs.3,40,000 Variable expenses Manufacturing 3,50 35, ,00,000 1,35,000 Marketing , ,000 65,000 Total Variable expenses , ,50,000 2,00,000 Contribution margin , ,00,000 1,40,000 Fixed expenses Manufacturing 50,000 Marketing 65,000 Administration 15,000 Total 1,30,000 Net profit before taxes 10,000 On comparing the budget and actuals presented in Table 5.1 & 5.2 we find that the profit before tax is down by Rs. 5,000 from the budgeted figure. Let us disaggregate the information and see the actual influences so as to understand the performance of the profit center. As a first step towards this we try to construct the flexible budget for the division. Table 5.3 presents the flexible budget calculations. 27

8 Management Control Table 5.3: Ibis Apparels Calculation of Flexible Budget for Period Sales Revenue (actual units sold x budgeted selling price) Undergarments 10,000 x Rs = Rs. 1,00,000 Undergarments 5,000 x 40,00 = 2,00,000 Total 15,000 3,00,000 Variable expenses Undergarments (actual units sold x budgeted variable expense) Manufacturing 10,000 x Rs = Rs. 40,000 Marketing 10,000 x Rs. 2,00 = 20,000 Total Rs. 60,000 Outergarments Manufacturing 5,000 x Rs = Rs. 75,000 Marketing 5,000 x 8,00 = Total 15,000 Rs. 1,15,000 Total Manufacturing Rs. 1,15,000 Variable expenses Total Marketing variabl Rs. 60,000 Expenses Total Rs. 1,75,000 Table 5.4: Ibis Apparels Calculation of Volume-mix and Expense-price Variances for period I (1-2) (2-3) Master Budget Flexible Budget Actual Volume & Mix Sales units 15,000 15,000 15, Sales Revenues (Rs. `000) U 40F Variable Expenses (Rs. `000) Manufacturing F 20 U Marketing F 5 U Total Variable Expenses F 25 U Contribution Margin U 15 F Fixed Expenses (Rs. `000) Manufacturing F Marketing F Administration 14 lit. I 1U Total fixed expenses F Profit before taxes ('000) 15 (24) U 34 F Expense & price 28 Notes 1) Sales Volume Variance = Master budget average contribution margin per unit x (Actual sales units - Master budget sales units) =(Rs. 1,64,000/15,000) x (15,000-15,000) = 0, 2) Sales mix variance = (Flexible budget average contribution per unit - Master budget average contribution per unit) x Actual sales unit = [ (Rs.1,25,000/ 15,000) - (1;64,000/15,000) ] x 15,000 = Rs. 39,000 U.

9 Sales volume and Mix Variances Profit Centres From Table 5.4 it is easy to understand the actual performance and see how the decline in profit after tax of Rs. 5,000 has resulted. We can see that the total sales volume of 15,000 has not change and hence no loss is attributable to volume variance. However, the sales mix does change and the drop in sales of high contribution outergarments results in a combined loss of Rs. 39,000, despite an increasing in sales of low contribution undergarments. That is, the company has lost a contribution of Rs. 51,000 on outergarments and gained a contribution of Rs. 12,000 on undergarments, thus incurring a loss of Rs. 39,000 on account of sale mix change. Undergarments Outergarments Master budget contribution Margin per unit Rs Rs Budgeted sales units 7,000 8,000 Sales mix % Actual sales 10,000 5,000 Actual sales mix % Price and Expense Variances The Rs. 40,000 favourable price variance in Table 5.4 arises from the fact that the average actual sales price exceeded the average flexible budget sales price. This can be disaggregated by products as follows: Undergarments (Rs ,000 = Rs. 10,000 U Outergarments (Rs ,000 = Rs. 50,000 F Rs. 40,000 F The total expense variance is Rs. 34,000 favourable which can be disaggregated as follows: Manufacturing variable Rs. 20,000 U Manufacturing fixed 10,000 F Rs. 10,000 F Marketing variable Rs. 5,000 U Marketing fixed 10,000 F Rs. 5,000 F Administration 1,000 U, Total Rs. 14,000 F Now we have a clear idea as to which segments of the business have contributed towards gains and which segments contributed towards losses. This information will help the profit center management and the top management to tackle the situation better. Summary of Variances Sales Mix variance Sales Price variance Expenses variances Rs. 39,000 U 40,000 F 14,000 F Total Rs. 5,000 F This analysis explains the actual performance of the profit center. 29

10 Management Control 5.5 PROFIT CENTER AS MOTIVATIONAL TOOL The behaviour of the divisional managers is often heavily influence by how their performance is measured. Thus, profit centres act as a tool for motivating such managers. However, it is quite debatable as to what extent, profit centres motivate them. Sometimes, it may demotivate them. The different arguments supporting the value of profit centre as motivational tool can be summarized as follows: 1) A profit centre manager is perceived to have a higher status in the organization and hence provides a psychological benefit to the division manager. It is argued that this perceived importance motivates him to perform better. By making the managers responsible for the profit performance of their divisions it tried to blend their objectives with the profit objectives of the company. 2) Profit centers tend to enhance the profit consciousness of the managers and subordinates within the division and hence they all strive for maximizing the profits of the division. This leads them to become conscious about the expenses in the division. They constantly try to evaluate every expense decision in the context of its relationship to profits. 3) The position of being a profit centre, manager in an organization brings in a sense of pride and belongingness, which in psychological terms provides sustenance for the needs of self actualisation and self-esteem. Most of the organization theorists argue on these lines. 4) The freedom and authority given managers imbibe a sense of independence and responsibility in the profit centre managers enabling them to strive for better performance. All these arguments are essential or inter-related and may at least partially contribute towards better performance when combined with a realistic system of rewards and punishments. Several studies have been conducted in India in this regard and they have concluded that there has been enhancement of the profit consciousness amongst the managers as the greatest motivational contribution of profit centers. Thus, profit centers do serve as a motivational' tool. 5.6 PERFORMANCE RELATED COMPENSATION If compensation is related to performance of the divisional managers, that certainly motivates them to put in their best. The compensation linked with performance should provide sufficient incentives to such managers so that they may be duly motivated to maximum contribution to the overall profits. It is also necessary that the measurement of profit of the centres should be undertaken objectively. Any objective measurement, linked with the effective system of adequate compensation, would be an important motivational factor. 30 The amount of and nature of compensation should be in the overall context of the organization. For that it is essential that the evaluation is undertaken at collective level and the incentives, through compensation, are quite realistic so as to motivate the divisional managers.

11 5.7 SUMMARY Profit Centres Profit centres aim to focus attention of the managers on control by making them responsible for both' revenues and expenses of the centres. Establishing and operating control system based on profit centres poses many practical difficulties such as deciding on the basis of profit measurement, allocation of expenses, and inter-divisional transfer prices. A major problem to be confronted in establishing profit centres is the very question of the boundaries of the profit centres within the organization. Profit centres may be an important motivational tool in organizations. There is evidence to show that they imbibe a sense of profit consciousness among division managers. The establishment of profit centres and the evaluation of performance using profit measures s pose several ticklish questions arising from combined influence of a host of factors. Profit centres, in order to be effective and enduring in an organization, would also require a performance related compensation system which may again pose several practical difficulties in the implementation of the idea. 5.8 KEY WORDS Book profit: Profit measured by matching revenues and expenses of an accounting period according to generally accepted accounting principles. Boundary conditions of profit centres: The boundaries of divisions in an organization should be so determined that overlapping is avoided. Where certain revenues and expenses are attributable to a particular division, they should be assigned only to that division. Performance evaluation: The process of assessment of the result of operations of the division by comparing against predetermined standards. The basis of such evaluation need not be restricted to any one variable. Profit centre: A division of an organization which is responsible for both revenue earned and. the expenses incurred by it. Such a division is usually evaluated on the basis of profit or a variant of it. As a general principle the measurement is restricted to revenues and expenses over which the division has control and hence the profit so measured may be different from the profit in the accounting sense. Profit contribution: This is actually the contribution made by a division towards the profits of an organization without setting off all those costs incurred by the. organization over which the division has no control. Real profit: The profit determined by valuing tale resources consumed by the division at their economic value to the business and not their historical cost. Variance: Deviation of actual of various elements of costs and revenue from the planned levels. 5.9 SELF ASSESSMENT QUESTIONS 1) Evaluate the purpose of comparing actual net income planned net income of profit centres. What problems, if any, may be confronted in this case? 31

12 Management Control 2) How do the boundary conditions influence the measurement of the performance of profit centres? 3) n what ways does the idea of profit and the difference in measuring profit affect the evaluation of profit centres? 4) How does profit centre motivate divisional managers? 5) What is performance related compensation? What are its advantages? What are the pitfalls against which we must guard ourselves before introducing the same FURTHER READINGS Bhatia, Manohar L., 1986, `Reorganising for a Decentralised ', Economic Times, January 4.,198, 1, `Profit Centres in Large Indian Industries', The Management Accountant, December., 1983, `Motivational Value of Profit Centres', Myth and Reality `Cost and Management', November-December., 1985, `Integrating Management by Objectives (MBO) and Responsibility Accounting', The CharteredAccountant, Volume XXXIII. Dean, Joel, 1957, `Profit Performance Measurement of Divisional Managers', The Controller, 25 September. Dearden, John, 1968, `Appraising Profit-Centre Managers', Harvard Business Review, 46, May-June. Dearden, John, 1960, `Problems in Decentralised Profit Responsibility', Harvard Business Review, 38, May-June. Parker, Lee D., 1979, `Divisional Performance Measurement: Beyond an Exclusive Profit Test', Accounting and Business Research, 9 Autumn. Solomons, David, 1965, Divisional Performance: Measurement and Control, Homewood: Richard D. Irwin. 32