Profit Center

A profit center is a segment of a business whose manager is responsible for generating revenue and controlling costs, and whose performance is measured by the profit it earns. Typical profit centers include divisions, regional operations, individual stores or branches, product lines and business units. The concept is a core part of responsibility accounting, which assigns each manager the financial results he or she can actually influence.

A profit center is one of several types of responsibility center. A cost center, such as a maintenance department or payroll team, is responsible only for costs. A revenue center, such as a sales office, is judged mainly on sales. An investment center is responsible for profit and also for the assets used to earn it, and is measured by return on investment or residual income. Organizing a company into profit centers usually goes hand in hand with decentralization, which pushes decisions down to managers who are close to customers and markets.

Profit center reports are often built on the contribution format rather than the external income statement. A common structure is:

• Revenue less variable costs gives the contribution margin.
• Less fixed costs that the manager controls, such as local staff and advertising, gives controllable margin.
• Less fixed costs traceable to the segment but not controllable by the manager, such as depreciation on equipment chosen by head office, gives segment margin.
• Common costs shared across the company, such as head office and corporate branding, are either left unallocated or shown separately.

A restaurant group treats each restaurant as a profit center. For one location, monthly revenue is $250,000 and variable costs (food, drinks and hourly wages) are $140,000, giving a contribution margin of $110,000. Controllable fixed costs, such as the manager's local marketing and salaried staff, are $35,000, leaving controllable margin of $75,000. Rent and depreciation on the building, decided by head office, are $30,000, giving a segment margin of $45,000. Head office allocates $20,000 of corporate overhead to each restaurant.

The segment margin ratio is:

Here $\text{Segment margin}$ is the profit after all costs traceable to the profit center and $\text{Revenue}$ is its sales. The ratio is $45,000 divided by $250,000, or 18 percent. The restaurant manager is best judged on the controllable margin of $75,000, since he cannot change the rent. Even if the allocated overhead turned the location into a reported loss, closing it would reduce total company profit, because the $45,000 segment margin would be lost while the $20,000 of corporate costs would remain.

Profit centers give managers a clear target, encourage them to think about both sales and costs, and make it easier for senior management to compare units and allocate resources. They also train managers for broader responsibilities. However, they can lead to problems:

• Arbitrary cost allocations can make profit centers look better or worse than they really are, and cause disputes.
• When units trade with each other, internal transfer pricing decides how profit is shared, and poorly set prices can lead managers to act against the company's overall interest.
• A focus on short-term profit can discourage investment, maintenance or training whose benefits come later.
• Units may compete with each other for customers instead of cooperating.

For these reasons, many companies combine profit measures with non-financial indicators and with measures that charge for capital, such as return on investment (ROI), and they use a flexible budget and budget variance analysis to separate volume effects from efficiency. For external reporting, public companies also disclose results by operating segment, which often correspond to their largest profit centers or divisions.