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 center, 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 cost center would be accounting departments 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 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.
Example of Proft Center
Let’s take an example of a profit center for better understanding.
Revenue from sale of product A,B,C are $15,000, $18,000 and $25,000. Direct Cost incurred for each of product A,B & C are $8,500, $10,700 and $14,200. Indirect cost is $15,000.
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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.
Profit Center Accounting
They are usually reported under segment reporting by publicly held companies. Private companies need not mandatorily report profit centers separately. The organization which maintains such responsibility centers 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 ledgers which help the organization to prepare accounting reports without any manual intervention.
For example, there is a financial service company 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 banking, and consultancy services. They would include revenue generated from such clients and expenses would include its employees on the payroll, computer/laptops used for providing such services. Similarly, for a company which is into producing and selling cold drinks, the profit center would be its sales team.
Advantages of Profit Center
- 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 the profit 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 target.
- 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 cost 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.
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.
This has been a guide to what is the profit center and its definition. Here we discuss an example of a profit center and its accounting along with advantages and disadvantages. You can learn more from the following articles –