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Cost Analysis, Profit Planning, and Control

MBA 603

Chapter 5 - Profit


Profit Strategies

Functional organizations are comprised of manufacturing or marketing functions performed by separate organizational


Divisionalization is an organization converted into one where each unit is

responsible for the manufacture and the

marketing processes.

Delegation of


Before delegating trade-off decisions to lower level managers, two key

considerations are:

Management should have access to relevant information for making the decision.

There should be some measurement tool to evaluate the effectiveness of the trade-offs.

Management must decide if the advantages of giving the profit responsibility offset the disadvantages,

Advantages of Profit


Quality of management decisions may improve because managers are closer to the action.

Speed of operating decisions may increase because a lack of headquarters intervention.

• Headquarters is relieved of “day to day”

decisions and concentrate on strategic problems.

Imagination and initiatives rise because of more freedom form headquarters.

Training grounds for future managers are provided by this organizational approach.

Advantages of Profit

Centers - Continued

Profit Consciousness is enhanced because managers face it every day.

• Profitability of the company‟s individual

components are highlighted by this approach.

Competitive performance is enhanced because their output is easily measured and they are responsive to pressure.

Difficulties of Profit


Loss of control occurs because of decentralized decision-making.

The quality of decisions at the unit level may be reduced if headquarters has more talent.

Friction may increase because of transfer pricing arguments.

There may be increased competition between organizational units that once cooperated.

Additional costs may arise because of the employment of divisionalization.

Disadvantages of

Profit Centers

General managers may not exist in the organization because opportunities may be stifled. Short-run profitability may be stressed more than long-term strategies because of this functional arrangement. Optimization of profits by the company as a

whole may not be attained because this is not a

“Perfect Management System”.

Business Units as

Profit Centers

Most business units are created as profit centers because they have a stronger influence on the “bottom-line”.

Constraints on business units are created by the culture of the organization and its size.

Therefore, business units represent trade- offs between unit autonomy and corporate constraints.

Constraints on Business Unit Authority Constraints From Other Business Units

Managing an Profit Center means:

Controlling the Product Decision (What to make)

Managing the Marketing Function (How, where)

Sourcing Decisions ( Manufacturing, raw materials)

If a BU controls all three there is no problem.

If there is a degree of integration the situation becomes more difficult.

Constraints on

Business Unit Authority

Constraints from Corporate Management can be grouped into three types:

Those from strategic considerations.

Those that result from conformity or uniformity.

The power of economies of scale or centralization.

The competition for investment money is a critical factor.

The business unit charter is a constraint. – Maintaining the “corporate image” is a

constraint as well.

Constraints on

Business Unit Authority

Corporate Level management and accounting systems are strong constraints.

Pay and Personnel policies also make BU‟s hard to manage.

In general the allocation of corporate services in terms of money and adequacy create problems as well.

Other Profit Centers

Functional Units are found within muli- business companies where the business units are based on functional issues.

• Management‟s decision as to what

constitutes a profit center is based on the influence a manager exerts on the bottom-

line of the unit. Examples are:

Manufacturing, Marketing, Service and Support Units


• Marketing activity becomes a “PC” when it

has control over the cost of products sold. The transfer price between the manufacturing and marketing allows the

marketing manager to manage the trade- offs between revenue/cost more


This especially occurs in foreign markets where distance and communications are



Manufacturing is usually an expense center which causes these problems:

Quality control may be compromised. Rush customer orders are frowned upon.

Difficult products may not be produced because of the standards in use as measurement tools.

One way to combat the problem with standards measurement and actuals is to

create a profit center.

Manufacturing -


Turning manufacturing into a profit center provides:

Selling price minus costs, and allocated marketing gives the PC some control over the bottom-line.

– The PC‟s must sell a large portion of their

output to external customers.

The size of their company and its complexity will determine the outcome of this decision process.

Service and Support


Units like maintenance, transportation, IT,

engineering, etc., can be made into profit


These entities charge internal customers for their services based on accepted corporate


The charges are based on some level of “usage”. Costs become the control factor.

The prevalence of this technique can be seen in Exhibit 5.2



There are two types of measurement for profit centers:

Management Performance - how well is the manager(s) doing.

Economic Performance - how well the profit center is doing as an economic entity.

A system needs to be designed to expose these reporting factors.

Types of Profitability


Contribution Margin - Revenue and variable costs, ignores fixed costs. (Exhibit

5.3, 5.4)

Direct Profit - Profit center‟s contribution to general overhead the corporation‟s profits.

Corporate expenses are ignored creating a motivational vacuums.

Controllable Profit - Expenses are divided

into controllable and non-controllable.

Major problem is it excludes HQ costs and confuses comparisons with other units.

Types of Profitability

Measures - Continued

Income Before Taxes - All corporate overhead is allocated based on the PC‟s

relative expenses (size).

Problem: Costs from accounting etc, are not controllable.

Problem: Costs are very hard to allocate properly.

Net Income - “Bottom-line Net Income is the major tool employed by firms because

it is convertible to cash flow.

Types of Profitability

Measures - Continued

Net Income - Bottom-line Net Income is the tool with various nuances:

Problem - After tax income is usually a constant.

Problem - Many tax decisions are made at corporate headquarters.

Foreign operations have very different tax problems as well.

Types of Profitability

Measures - Continued

Revenues - Recognition of when revenues are earned becomes an interesting problem.

Problem: Common revenues generated by two or more BU‟s could cause difficulty.

Orders become the segregating point in some companies who try to alleviate this area of concern.

Management considerations should focus on “managers should be measured on those

items they can influence, even if they do not

have total control over those items.

Chapter 6

Transfer Pricing

Objectives of Transfer Pricing:

It should provide each business unit with relevant data to determine optimum trade-offs for revenue and costs.

Goal Congruence should be paramount - BU‟s profits will improve company profits.

Economic Performance of the BU should be assisted or simplified.

System should be simple and easy to administer.

Chapter 6

Transfer Pricing

Transfer Price - the value placed on a transfer of goods and services in

transactions which at least one or two profit centers are involved in on a continuous basis.

Fundamental Principle - The transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased

from outside vendors.

Chapter 6

Transfer Pricing

There are two main things to consider here:

Sourcing Decision - should the company produce the product inside or buy it outside?

Transfer Price Decision - Produced inside what is the proper price to use?

Review Exhibit 6.1 survey information. The process appears to be wide spread.

Chapter 6

Ideal Situation

Market Price is the best form to insure goal congruence if the following factors are in place:

Competent People are vital to the system. Good Atmosphere and cooperation among PC‟s

A Market Price is well known and easy to identify by all parties.

Freedom to Source allows managers to obtain goods, etc. where ever they find attractive ricin

- kee

s the

la ers honest

Chapter 6

Ideal Situation

Full Information means managers have access to alternatives and relevant costs.

Negotiation is a process that works well within the organization and PC‟s.

If these factors are present then the MARKET PRICE system will create goal congruence for the entire organization.

Chapter 6

Constraints on


Limited Markets create problems because:

The degree of internal capacity might limit external sales. Intermediate goods become hard to obtain because of vertical integration.

If the company is the sole producer of a differentiated product there may be no outside source.

If the company has invested large amounts in capacity, it will be unlikely to use outside sources unless the vendor has lower costs.

Chapter 6

Competitive Prices

Even in limited markets, the transfer price that best satisfies the PC‟s requirements

maybe the competitive price.

Competitive Price measures the contribution of each profit center to the total company profits.

It measures how ell a PC is doing against it known competitors.

Chapter 6

How to Find a

Competitive Price

Published Market Prices can be used for transfer pricing decisions.

Bids may set market prices - half in, half out, not all products are let to bid.

Production Profit Center sells similar products in outside markets - it

replicate that price.

Buying Profit Center purchases similar products from outside markets - it may

replicate that price.

Chapter 6

Excess or Shortage

of Industry Capacity

An arbitration committee will decide if the transfer price purchase will be undertaken if there is idle capacity

within a firm.

If the company will lose profit from the decision to out source, then the competitive price theory takes command of the situation.

Cost Based transfer pricing is then

Chapter 6

Cost Based Transfer


If competitive prices are not available, then prices based on cost and a profit margin are calculated.

Two problems exist with this method:

Definition of costs Calculation of acceptable profits

Chapter 6

Cost Basis and Profit


The usual basis is standard costs.

Actual costs will pass on inefficiencies to the purchasing unit and cause internal

problems. Two important decision for Markup are:

What is the level of Markup. And what is the level allowed by the company.

Percentage of Costs Percentage of Investment

Chapter 6

Upstream Fixed

Costs and Profits

Transfer pricing can create significant problems for an integrated company.

Goal congruence may become an issue because of the charters of each PC or BU.

Several Ways to Solve the Dilemma:

Agreement among Business Units - committees between buying and selling units discuss problems.

Two Step Pricing - Each unit sold = „s standard variable cost, monthly fixed charges associated with facilities for the buying unit. (See Exhibit 6.2)

Chapter 6

Two Step Pricing

Some points for two step pricing are:

Monthly fixed charge should be negotiated periodically.

Accuracy of costs and investment allocations need to be reviewed based on capacity.

Under this pricing system - manufacturing unit‟s performance is not affected by the sales

volume of the final unit.

– Method is similar to “take or pay” pricing used

by public utilities.

Chapter 6

Profit Sharing

The system operates by:

Product is transferred to marketing unit at standard variable cost.

After product is sold - the business units share the contribution earned - Selling price minus marketing and variable manufacturing.

Problems with the system are:

– Contribution between PC‟s are difficult

Arbitrarily dividing the contribution muddles PC individual performance

Manufacturing Contributions depends on Marketing unit‟s selling ability.

Chapter 6

Pricing Corporate


These allocations are not transfer prices and are basically two types:

Central Services that receiving unit must accept charge but can control usage.

Central Services that the business unit can decide whether or not accept.

Control over service focuses on efficiency or the amount of the service.

Chapter 6

Control Over Amount

of Services

Three methods of charging:

Standard Variable Cost of discretionary services, if it pays less than normal, then they will use more, etc.

Full Cost plus the variable standard cost which are the firm‟s long term costs and should be


Market Price or the Standard full cost plus the profit margin should focus on the employment of assets and the return that is necessary.