Management Control Systems Chapter 5 Profit Centers Management Control Systems Chapter 5 July 2014 Iwan Pudjanegara SE., MM.

The Nature of Profit Centers Profit : the difference between the revenues and expenses. Profit = Revenues - Expenses Profit Center : an organization unit in which both revenues and expenses are measured in monetery terms. July 2014 Iwan Pudjanegara SE., MM.

The Nature of Profit Centers A functional organization is one in which each principal manufacturing or marketing function is performed by a separate organization unit. Divisionalization : the process when such an organization is converted to one in which each major unit is responsible for both the manufacture and the marketing. July 2014 Iwan Pudjanegara SE., MM.

Expense/Revenue Trade-offs Increase expenses with the expectation of an even greater increase in sales revenue. Two conditions should exist: The mgr should have access to the relevant information needed making such a decision. There should be some way to measure the effectiveness of the trade-offs the manager has made. July 2014 Iwan Pudjanegara SE., MM.

Advantages of Profit Centers The quality of decisions may improve because they are being made by managers closest to the point of decision. The speed of operating decisions may be increased since they do not have to be referred to corporate headquarters. July 2014 Iwan Pudjanegara SE., MM.

Advantages of Profit Centers Headquarters management, relieved of day-to-day decision making, can concentrate on broader issues. Managers, subject to fewer corporate restraints, are freer to use their imagination and initiative. July 2014 Iwan Pudjanegara SE., MM.

Advantages of Profit Centers Because profit centers are similar to independent companies, they provide an excellent training ground for general management. Profit consciousness is enhanced since managers who are responsible for profits will constantly seek ways to increase them. July 2014 Iwan Pudjanegara SE., MM.

Advantages of Profit Centers Profit centers provide top management with ready-made information on the profitability of the company’s individual components. Because their output is so really measured, profit centers are particularly responsive to pressures their competitive performance. July 2014 Iwan Pudjanegara SE., MM.

Difficulties with Profit Centers Decentralized decision making will force top mngmt to rely more on management control reports than on personal knowledge of an operation, entailing some loss of control. If headquarters management is more capable or better informed than the average profit center manager, the quality of decisions made at the unit level may be reduced. July 2014 Iwan Pudjanegara SE., MM.

Difficulties with Profit Centers Friction may increase because of arguments over the appropriate transfer price, the assignment of common costs, and the credit for revenues that were formerly generated jointly by two or more business units working together. Organization units that once cooperated as functional units may now be in competition with one another. An increase in profits for one manager may mean decrease for another. July 2014 Iwan Pudjanegara SE., MM.

Difficulties with Profit Centers Divisionalization may impose additional costs because of the additional management, staff personnel, and record keeping required , and may lead to task redundacies at each profit center. Competent general managers may not exist in a functional organization because there may not have been sufficient opportunities for them to develop general management competence. July 2014 Iwan Pudjanegara SE., MM.

Difficulties with Profit Centers There may be too much emphasis on short-run profitability at the expense of long-run profitability. To get high current profits, the manager may skimp on R&D, training programs or maintenance. There is no completely satisfactory system for ensuring that optimizing the profits of each individual profit center will optimize the profits of the company as a whole. July 2014 Iwan Pudjanegara SE., MM.

Business Units as Profit Centers Constraints on Business Unit Authority One of main problems occur when BUs must deal with one another. Three types of decisions to control over a profit center : The Product Decision, The Marketing Decision, and The Procurement or Sourcing Decision. July 2014 Iwan Pudjanegara SE., MM.

Business Units as Profit Centers The Product Decision : What goods or services to make and sell. The Marketing Decision : How, where, and for how much are these goods or services to be sold? The Procurement or Sourcing Decision: How to obtain or manufacture the goods or services. July 2014 Iwan Pudjanegara SE., MM.

Business Units as Profit Centers Constraints from Corporate Mgmt Three types of constraints from corporate management : Those resulting from strategic considerations Those resulting because uninformity is required Those resulting from the economies of centralization. July 2014 Iwan Pudjanegara SE., MM.

Other Profit Centers Functional Units Other Organizations Marketing Manufacturing Service and Support Units Other Organizations A company with branch operations that are responsible for marketing their products in a particular geographical area. July 2014 Iwan Pudjanegara SE., MM.

Measuring Profitability 2 types of profitability measurements used in evaluating a profit center : The measure of Management Performance  focuses on how well the manager is doing. The measure of Economic Performance  focuses on how well the profit center is doing as an economic entity. July 2014 Iwan Pudjanegara SE., MM.

Measuring Profitability (Example of a Profit Center Income Statement) July 2014 Iwan Pudjanegara SE., MM.

Measuring Profitability Five different measures of profitability Contribution Margin Direct Profit Controllable Profit Income before taxes Net Income July 2014 Iwan Pudjanegara SE., MM.

Five Different Measures of Profitability Contribution Margin (CM) The spread between revenue and cost of sales + variable expenses. CM = Revenue – (CofS + Var. Exp) Purpose: to measure the performance of profit center managers since fixed expenses are beyond control, so focus on maximizing contribution. July 2014 Iwan Pudjanegara SE., MM.

Five Different Measures of Profitability Direct Profit (DPro) Reflects a profit center’s contribution to the general overhead and profit of the corporation. DPro = CM – Fixed Expenses Excluded expenses incured at headquarters. Weakness: it does not recognize the motivational benefit of charging headquarters costs. July 2014 Iwan Pudjanegara SE., MM.

Five Different Measures of Profitability Controllable Profit (CP) Disadvantage: because it excludes noncontrollable headquarters expenses, it cannotbe directly compared with either published data or trade association data reporting the profits of other companies in the industry. CP = DPro – Controllable Corporate Charges July 2014 Iwan Pudjanegara SE., MM.

Five Different Measures of Profitability Income before Taxes (IBT) All corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. IBT = CP – Other Corp. Allocations July 2014 Iwan Pudjanegara SE., MM.

Five Different Measures of Profitability Net Income (NI) Measure the performance of domestic profit centers according to bottom line, the amount of net income after income tax. NI = IBT - Taxes July 2014 Iwan Pudjanegara SE., MM.