What is a Profit Center?
A profit center is that business unit or segment of an organization that is responsible for generating revenue and contributing towards its profit. It not only generates revenue and at the same time minimizes its cost so that profit margin is higher. The head or manager of this unit or segment is responsible for taking decisions that will drive more sales or revenue which will increase cash inflow and also cut down its costs i.e; less cash outflow, in return to generate higher profit.
Every organization typically has 3 main business units – cost centerCost CenterCost center refers to the company's departments that don't contribute directly to the corporate revenue; however, the firm has to incur expenses for keeping such units operative. It comprises research and development, accounting and human resource departments.read more, profit center, and investment center.
- A cost center is that unit, which consumes resources of an organization, thereby increasing its cost without contributing towards its profit. A perfect example of a cost center would be accounting departmentsAccounting DepartmentsThe accounting department looks after preparing financial statements, maintaining a general ledger, paying bills, preparing customer bills, payroll, and more. In other words, they are responsible for managing the overall economic front of the business.read more or marketing department.
- An investment center is responsible for utilizing the company’s capital and resources, contributing to its revenue. Its decision is majorly related to purchasing, disposing, and selling of capital assets and investments. They typically lie between cost and investment center. A perfect example of a profit center would be selling or sales department.
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Example of Proft Center
Revenue from sale of product A,B,C are $15,000, $18,000 and $25,000. Direct CostDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more incurred for each of product A,B & C are $8,500, $10,700 and $14,200. Indirect cost is $15,000.
Profit will be calculated for each product as they represent a separate profit center. The indirect cost will be divided equally as no other parameter is available.
| Particulars | Product A | Product B | Product C |
|---|---|---|---|
| Revenue | $15,000 | $18,000 | $25,000 |
| Direct Cost | ($8,500) | ($10,700) | ($14,200) |
| Indirect Cost | ($5,000) | ($5,000) | ($5,000) |
| Net Profit | $1,500 | $2,300 | $5,800 |
Profit Center Accounting
They are usually reported under segment reportingSegment ReportingSegment Reporting is the disclosure of financial details of key units or segments by public companies and is based on certain regulatory requirements. read more by publicly held companies. Private companiesPrivate CompaniesA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. read more need not mandatorily report profit centers separately. The organization which maintains such responsibility centersResponsibility CentersThe term "Responsibility Center" refers to a specific segment or unit of an organization for which a specific manager, employee, or department is held accountable and responsible for its business goals and objectives.read more will have the accounting structure as such, where they can get detailed information about each center by each product and service, divisions, geographical location, shops, and offices. All the cost and revenue are automatically associated with ledgersLedgersLedger in Accounting, also called the Second Book of Entry, is a book that summarizes all the journal entries in the form of debits & credits to use for future reference & create financial statements. read more, which help the organization to prepare accounting reportsPrepare Accounting ReportsAccounting reports are created using a company's accounting data to check ledger-by-ledger transactions over a given time period. Accounting reports also include financial statements such as cash flow statements, profit and loss statements, and balance sheets.read more without any manual intervention.
For example, there is a financial service company that provides both products and services to its customers. Its products would be providing customized accounting and reporting software, and its services would include providing accounting services, investment bankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more, and consultancy services. They would include revenue generated from such clients, and expenses would include its employees on the payrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits.read more, computer/laptops used for providing such services. Similarly, for a company that is into producing and selling cold drinks, the profit center would be its sales team.
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Advantages
- It helps an organization to focus on details on how every sub-unit or department under the profit center is performing. For example, – an organization is into multi-product sales. This will help them understand how much revenue is being generated from each product further divided into each geographic location, shops, etc.
- It helps the organization determine where and how the costs are incurred.
- Based on data available, the budget is set for such centers, which helps managers and employees to spend as per budget and also meet the target. This also acts as a motivation to employees as it can affect their performance and earn them extra incentives on achieving targets.
Disadvantages
- A big organization which is into products and services both will have many profit centers. Because these centers are reported separately segment-wise, it may lead to unnecessary competition within the organization.
- It’s also difficult for the organization to allocate indirect costIndirect CostIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc.read more amongst so many centers as the use of resources varies from center to center.
- Some organization is so focused on generating more and more profit for their business, that the decisions taken by them are not in the best interest of society or business as a whole.
Conclusion
Every company has to identify its profit center depending upon its characters as they are an important key in driving profits for the business. The owners and shareholders are very keen to know how the company is performing in terms of its revenue, and a comparison is also made amongst each center within the industry to understand the revenue and profit trend. It helps the organization to rank their profit centers according to the profit generated by them. This helps management in an optimal allocation of resources so that they are best used in generating profits, and cost can be reduced for less profit-making units.
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