5.04 – Focusing On Your Profit Centres
A business consists of different revenue streams, and some are more profitable than others. It would be unusual if every source of sales were equally profitable. A common practice is to divide the business into separate profit centres, allowing for a clearer understanding of each part’s profitability. For example, a car dealership might separate new car sales, used car sales, service work, and parts sales into distinct profit centres. Similarly, if your business sells products both at retail prices to individual consumers and at wholesale prices to other businesses, you should separate these two main sources of sales and create a profit centre for each.
Determining Profit Centres
Deciding how to partition a business into profit centres is a management decision. The first question is whether the segregation of sales revenue into distinct profit centres helps manage the business more effectively. Generally, the answer is yes. This information helps focus attention and effort on the most profitable sources of revenue. Comparing different profit centres highlights areas that may not generate enough profit or could be losing money.
Typically, a business creates a profit centre for each major product line and for each location or territory. There are no strict rules; at one extreme, each product could be defined as a profit centre. Businesses keep records for every product they sell, which can result in very detailed reports. However, the more practical approach is to divide the business into a reasonable number of profit centres and focus on the reports for each.
A profit centre is a fairly autonomous source of sales within a business. For example, a hardware store selling outdoor clothing would consider this a distinct profit centre. The first step in evaluating this is determining the gross margin for the outdoor clothing department. The cost of goods sold is deducted from sales revenue to find the gross margin. Knowing whether outdoor clothing is a high gross margin source of sales is crucial for the store owner.
Direct Operating Costs
The report for a profit centre doesn’t stop at the gross profit line. One key purpose of setting up profit centres is to match direct operating costs against the sales revenue of the profit centre as closely as possible. Direct operating costs are those clearly assigned to the sales activity of the profit centre. Examples of direct operating costs include:
- Commissions paid to salespersons
- Shipping and delivery costs
- Inventory shrinkage and write-downs
- Bad debts from credit sales
- The cost of employees working full-time in the profit centre
- Advertising costs for products sold in the profit centre
Indirect Operating Costs
Assigning direct operating costs to profit centres doesn’t cover all business costs. Many indirect operating costs benefit all, or at least two or more, profit centres. Examples include the employee cost of the general manager, the cost of the accounting department, general business licenses, real estate taxes, interest on business debt, and liability insurance.
Accountants have devised methods for allocating indirect operating costs to profit centres. However, these methods can be flawed and arbitrary. Often, there is no significant gain in useful information by allocating these costs. Ending the profit centre report after direct operating costs usually provides all the necessary information.
Contribution to Aggregate Profit
The bottom line of a profit centre report measures profit before accounting for general business operating costs and interest expense (and income tax expense, if applicable). This bottom line is more accurately called the contribution toward the aggregate profit of the business as a whole. Although the term “profit” is commonly used for the bottom line of a profit centre report, it does not carry the same meaning as the bottom line of the overall income statement for the entire business.
By focusing on profit centres, a business can gain valuable insights into which areas are most profitable and which need improvement. This approach enables more targeted and effective management, ultimately leading to better financial performance.
