Profit center

[edit] Overview
A profit center is a section of a company treated as a separate business. Thus profits or losses for
a profit center are calculated separately

A profit center manager is held accountable for both revenues, and costs (expenses), and
therefore, profits. What this means in terms of managerial responsibilities is that the manager has
to drive the sales revenue generating activities which leads to cash inflows and at the same time
control the cost (cash outflows) causing activities. This makes the profit center management
more challenging than cost centre management. Profit center management is equivalent to
running an independent business because a profit center business unit or department is treated as
a distinct entity enabling revenues and expenses to be determined and its profitability to be
measured.

Business organizations may be organized in terms of profit centers where the profit center's
revenues and expenses are held separate from the main company's in order to determine their
profitability. Usually different profit centers are separated for accounting purposes so that the
management can follow how much profit each center makes and compare their relative
efficiency and profit. Examples of typical profit centers are a store, a sales organization and a
consulting organization whose profitability can be measured.

Peter Drucker originally coined the term profit center around 1945. He later recanted, calling it
"One of the biggest mistakes I have made." He later asserted that there are only cost centers
within a business, and “The only profit center is a customer whose cheque hasn’t bounced.”[1]

What Does Profit Center Mean?

The branch or division of a company that creates profits individually and separately from the main
organization

A profit center is a unit of a company that generates revenue in excess of its expenses. It
is expected that, through the sale of goods or services, the unit will turn a profit. This is
in contrast to a cost center, which is a unit inside a company that generates expenses
with no responsibility for creating revenue. The only expectation a cost center has is to
lower expenses whenever possible while staying with a specific budget that is
determined at the corporate level.

Beyond that simple definition, the term "profit center" has also come to represent a
form of management accounting that is organized around the profit center concept.
Companies that have adopted the profit center system have organized all of their
business units as either profit centers or cost centers, and all company financial results
are reported in that manner. Adopting a profit center system often requires a radical
shift in corporate philosophy and culture, but it can yield great returns in net before tax
(NBT) profits. According to an article in Business Solutions, the data collection company
Data Recognition, Inc. made the shift to a profit center-based system and was pleased
with the results. "We saw the importance of evaluating, individually, areas of our
business that are distinctly different," said Steve Terry, the company's vice president of
systems. "The profit centers have allowed us to better identify specific gains and losses.
And that's critically important for a growing business."

All companies, no matter what size, have both cost and profit centers (although, if it is a
single-person company, that company would really have profit and cost activities, since
all business "units" are the same person). For example, in most companies, units such as
human resources and purchasing are strictly cost centers. The company has to spend
money to operate those units, and neither has any means of producing a profit to offset
those expenses. They exist solely to make it possible for other areas of the company to
make money. However, without those two departments, the company could not survive.
Examples of profit centers would be the manufacturing units that produce products for
sale to consumers or other businesses. The sale of those products generates a profit that
offsets the expense of creating the products.

All companies have profit centers and cost centers, but not all companies organize their
accounting practices around the profit center concept. In fact, most companies do things
the time-honored way, producing overall profit and loss statements for the company as
a whole, without making each business unit accountable for generating a profit.

TURNING A COST CENTER INTO A PROFIT

CENTER
A cost center may actually provide services that could generate a profit if they were
offered on the open market. But in most corporate environments, cost centers are not
expected to generate a profit and operation costs are treated as overhead. Departments
that are typically cost centers include information technology, human resources,
accounting, and others. However, the complacent acceptance that some departments
will always be cost centers and can never generate a profit has changed at some
companies. They recognize that cost centers can turn into profit centers by taking the
services they used to automatically provide to the company's other business units and
making those services available for a fee. The company's other business units are then
required to pay for the services they used to get for free. But in return, they are allowed
to go outside the company and contract with another firm to provide those services.
Likewise, the former cost center may be allowed to sell its services to other companies.
The expectation is that this free market system will improve performance through
increased competition while increasing profits by turning former cost centers into profit
centers.

"When a business firm becomes a corporate community of entrepreneurs who buy, sell,
and launch new products and services internally as well as externally, it gains the same
creative interplay that makes market economies so advantageous," said management
professor William E. Halal when discussing making the move to profit center-based
operations in USA Today Magazine.

As an example of how a cost center may be turned into a profit center, consider a
company's information technology (IT) department. This department may provide such
services as computer-aided design, network administration, or database development to
other units of the company. These services have value, and they are important to the
company's overall success, but they do not generate a profit. IT may charge the "cost" of
its services back to the department that requested them, but it does not make a profit
because it charges only for its actual costs incurred, without adding an extra margin for
profit. The unit that requested the services absorbs the cost as part of its overhead; or, in
some companies, the cost is not charged back and is simply part of the company's
overall overhead.

There are two ways that the IT department could make the switch from cost center to
profit center. First, instead of writing off its services to overhead or charging them at
cost, the IT department could be allowed to bill other departments for its services at
going market rates. The profit earned for the services would exceed the cost of providing
the services. While all the money in this transaction would stay within the company,
thus making it seem to be a meaningless way of creating a profit for the IT department,
it is done for two reasons. One is to ensure that the IT department remains competitive
with outside vendors providing the same services, and the other is to ensure that the
company's other business units do not waste money on needless IT expenditures. Paying
competitive market rates prevents the operating units from wasting money, thus making
them more competitive.

If the IT department is turned into that type of profit center, it is considered to be a

"zero profit center." In that situation, the department is expected to compete with
outside vendors for the company's information technology budget. If a division of the
company selects the IT department as its technology provider, it has done so because it
feels it cannot purchase the same quality services for a lower price from an outside
vendor. It will not actually "pay" the IT department for its services, but it will be charged
by the IT department for services rendered, and those charges will be subtracted from
the division's budget. Thus, the IT department does not really take in any revenue, but
neither does it cost the company any money because the division that utilized its
services would have had to spend money to hire an outside vendor. This, then, creates a
zero profit center. Such a business model forces the IT department to be more
competitive in its pricing and to provide high quality work if it hopes to survive as an
operating unit.

The second way the IT department could become a profit center is if the company
determined that the department was one of the best in the industry, better in fact than
some companies that existed just to provide IT services. The company could then allow
the department the freedom to sell its services to outside customers. Thus, the
department would still operate as a cost center in its dealings with other units inside the
company, but it would operate as a profit center when it provided services to outside
companies. This method of operation has become far more common in the 1990s and
beyond, as companies seek new revenue streams that have low start-up costs.
If the IT department exists only as a cost center, it faces enormous pressure to provide
services at the lowest possible costs. Because it does not generate profits, it must
constantly fight to remain in existence and must fight off attempts to slash its budget to
free up cash for the company's profit centers. Just as the company's senior management
could decide that the IT department was good enough to operate as a profit center by
soliciting outside clients, so too could it decide that the department is behind the times
and is not providing adequate services. This would result in management choosing to
shut down the department and contract with an outside vendor for the company's IT
needs.

PROFIT CENTERS AND THEIR CHANGING ROLE

IN INDUSTRY
In large companies, especially manufacturing companies, it has become a fairly common
occurrence to break the company into small pieces, with each piece operating as a profit
center that has to compete for business. In this manner, a large business can suddenly
find itself operating as a small business. For example, say the Acme Company produces
a finished product that is composed of five smaller parts. Instead of operating as one
large company that produces all five parts needed for the finished product, Acme has
decided to split into six separate units—one that assembles and sells the finished
product, and five smaller companies that each produce one of the parts needed for the
finished product. Beyond Acme, there are other companies that produce those same five
parts needed to produce the finished product.

Each of the five part manufacturers is now operating as a separate profit center,
reporting to Acme's corporate office. Each has to determine its own methods of
operation, and each has to determine how it is going to show a profit. There may be
internal agreements in place that mandate that each of the five units will continue to
work together to produce the finished product, or Acme may throw things wide open by
stating that there is no corporate mandate forcing the five divisions to continue to work
together.
If the latter model is chosen, the corporation may have decided that, while the company
could continue making steady—but small—profits if it kept using the five units together
as it had for decades, there was a chance that the company could make huge profits if it
made each of the five units accountable for its own bottom line and opened up the
manufacturing process to both internal and external competition. In such a radical
environment, it was conceivable that one of the five units could go bankrupt and cost the
company money, but senior management believed that the hugely increased profits in
the other four units, and the resulting higher profit margin realized by the sale of the
finished product, would more than offset the loss of one unit.

Thus, each of Acme's five units, formerly divisions within the larger company that were
not accountable for directly generating profits, were now separate entities that had to
show a profit to continue operating. Each of the units had gone from a cost center
mentality—buying materials to produce part of a product that showed up on the
company's overall bottom line—to a profit center mentality, responsible for showing a
profit based solely on the production and sale of its one part. As part of the shift to
becoming a profit center, each of the five units would also be free to sell its part on the
open marketplace. Acme might make that freedom a restricted one that prevented sales
to a direct competitor, or it might take the full plunge and make the unit a fully stand-
alone company that was free to sell its part to any other company in the market,
including direct competitors. That decision would dictate whether Acme's move was a
small one, designed to encourage each of its five units to think creatively and work
harder to perform at a high level, or a large one, designed to change the very core of the
company's business in a bid for higher profits.

PROFIT CENTERS AND SMALL BUSINESSES

When operating a small business, it may not be practical to use the profit center concept
initially because the business is so small. Fewer employees mean fewer business units,
which means fewer opportunities to create profit centers. In addition, in a small
business, the president or the chief financial officer is probably monitoring financial
results very closely, which means that he or she knows exactly where profits and losses
are occurring. However, as a small business begins to grow, establishing profit centers
often makes sense. Data Recognition, Inc. found that switching to profit centers made
sense as the company increased in size. "Establishing profit centers, and generating
daily profit/loss statements, has allowed us to better identify, and correct, our
weaknesses," said vice president Steve Terry.

Even without adopting the profit center accounting concept, the idea of profit centers
has value for small businesses in that they should always be looking for new ways to
generate revenue. When operating a small business, there are essentially two ways to
create a new profit center. The first method is to create an extension of the original
business—a new product related to existing products, or new services that build on
services that are already offered. The second method is to create an entirely new
business altogether that can operate using the first business's corporate infrastructure
(at least initially) and that can be operated at the same time as the original business.

The rapid spread of the World Wide Web has created an unprecedented method for
creating new profit centers. Almost every company today has a Web site to dispense
public relations information and to make it easier for customers to contact the company,
but more and more firms are recognizing that there is money to be made on the Web.
Most corporate Web sites begin life as a cost center, since they are initially just used to
disseminate information, but most can be transformed into a profit center.

When seeking new profit centers, small business entrepreneurs should avoid business
models that have regularly failed on the Web. These include setting up an entertainment
site that attempts to charge a fee for that entertainment; relying on advertising as a
revenue stream, as banner advertisements are proving to be quite unsuccessful in
bringing in new customers; charging subscription or other visitor fees; and biting off
more than you can handle by attempting to establish business-to-business sales that
may not be achievable.

A profit center is a sector within a company that is expected to be profitable, with earnings that outstrip its expenses. Some
profit centers can be a sizable source of revenue for the parent company and may be an anchor or mainstay of its business.
The profits they generate can be used to finance other areas of the business, as well as to pay for expansion into new areas
of the market and other activities that a company may want to engage in.
By contrast, a cost center is a unit that is not necessarily expected to generate revenues. Cost centers focus on sticking
within a set budget to accomplish their work. Profit centers are expected to use as many means as possible to reduce costs
and increase their profit margin. This requires innovative and aggressive management. In cost centers, by contrast,
managers can focus on developing and maintaining budgets without being worried about how much money their
departments are bringing in.

Accounts for a profit center are processed separately and it is treated almost like an independent entity within the larger
company. Profit centers are responsible for constant development of new products and services to appeal to customers and
increase revenues. They are also the core of the business, and may provide the services it is most well known for.
Operations in the profit center sustain lesser-known aspects of the business that can play an important role in customer
loyalty.

Pharmaceutical companies are an excellent example of the profit center and cost center model. Most companies have
several highly profitable divisions that market and sell popular medications. These departments are leaders for the
company, keeping profits high. The research and development division, on the other hand, is a cost center. It does not
generate revenues directly and can in fact be very expensive to run. However, without the cost center, the business would
fail to thrive in the long term.