A Profit Center is a department or a unit, or a responsibility center inside an organization that is capable of generating revenues, as well as profit or loss. Or it is a department/division that contributes directly to a company’s bottom line.
Such departments are extremely crucial to an organization as they are the primary performance drivers. These centers also have their own costs, making it easy to independently calculate their profit or loss.
Generally, management uses the performance of this center to decide whether or not to give more resources to it. Also, management may decide to close the low-performing profit centers or loss-making profit centers. Usually, the head of the center has the authority to make decisions regarding the working of the center.
When reporting the financial numbers, a public company generally reports the numbers of profit centers under the segment reporting section. There is no compulsion for a private firm to report the profit centers’ numbers separately.
Example of Profit Centers
Company A makes mobile. It has to make several components, such as screens, chips, cameras, and more, to make a mobile. Company A treats each component unit as a separate profit center. This allows the company to better manage the performance of each unit, as well as track their performance. Each unit, such as the one making the camera, would manage and is responsible for its performance as well.
Similarly, a grocery chain can make different departments selling different products into profit centers. For instance, the grocery chain can divide segments selling vegetable oil or home products into profit centers.
Characteristics of a Profit Center
Following are the characteristics:
- It works as a separate unit or a reporting center.
- Profit centers have their own accounting and usually calculate their profit or loss separately in their own way.
- They have the responsibility to generate revenues.
- They also help management in the allocation of resources and creating strategies for improving performance.
Importance of Profit Center
The following points help to bring out the importance of profit centers:
- If a company divides its business into profits centers, it makes it easier for the management to focus on each unit.
- The presence of profit centers makes it easy for the management to allocate resources among them. The preferred and the simplest way to distribute the resources amongst the various centers is to do the allocation on the basis of their individual performance.
- The presence of the different departments, such as operating groups and profit centers, helps to distribute the responsibilities as well. Moreover, each department can be held responsible for its performance also.
- With the creation of profit centers, it becomes easier to identify if the cost they incur is more than the revenue they are generating. This helps the management as well as the department to take corrective actions.
- It gets easy for the stakeholders to track the performance, including cost and revenue, of all these profit centers.
- As individual center performance can be judged, it also helps calculate and identify variances and comparisons between the budgeted vs. actual costs.
Advantages and Disadvantages
Following are the advantages:
- It helps management create strategies for the units that are not performing well. Thus, eventually leading to more revenues.
- If management focuses on boosting the units’ revenue-generating capacity, then it results in boosting the overall productivity.
- Profit centers help management to categorize the units into varying categories, such as less profitable, more profitable, loss-making, and more.
- The performance analysis and their contribution to the overall bottom line help the management to understand and appreciate the importance, strength, and weaknesses of each department/unit/center.
- It helps with segmental reporting as well.
These are the drawbacks:
- It may get difficult and confusing to allocate resources and funds if an organization has too many such centers.
- If an organization has too many profit centers, then it may put pressure on the resources and the staff. Accounting, split of cost and revenue, and all such activities become time and cost-consuming as well as quite tedious.
- It could happen that a decision on the basis of one profit center may not benefit the whole organization.
- The presence of too many profit centers may encourage unhealthy competition within the company, which may adversely affect the organization’s overall performance.
Types of Profit Center
Primarily there are two types:
Departments in Organization – small departments in an organization, such as the sales department and investments department, are turned into profit centers.
Strategic Units in Big Organization – a bigger organization, may have different segments or strategic units that contribute to the revenue directly. Management may decide to identify these units individually as one profit center. For example, a bank may have different divisions, such as investment banking, wealth management, retail baking, etc. Management may turn each of these units into a separate profit center.
Profit Center vs. Cost Center
It may not be possible for a company to divide all its department into profit centers. This is especially true for the units that provide essential services. For example, the human resources department, accounting department, or customer service departments as all these department do not contribute to the bottom line. Of course, they have an indirect contribution, though.
Even though these centers do not generate any revenue or are not responsible for generating profits, they do have their costs. Thus, such departments are the cost centers. Management determines the performance of cost centers by comparing their actual costs with the estimates.
Read Profit Center vs. Cost Center to know more about it in detail.
Profit center identification and split are extremely crucial in improving the overall performance of an organization. This will also help the organization in optimizing and balancing resource allocation. However, when categorizing departments into profit centers, management must consider the activities they perform. In every organization, there are some service departments that do not perform any profit-generating activities. Thus, one must never make these departments profit centers. But these are still crucial for the smooth functioning of the organization.