Understanding a Profit Center
A Basic Understanding of the Business Term Profit Center
In the business world, a profit center is an area of a company that adds directly to its bottom line profit. Like with all areas of life following the 80/20 rule, also known as Pereto’s Law, most of a company’s profits are likely to come from only a handful of operations, products, or divisions. Microsoft has thousands of products, but the major profit centers are the Windows operating system and the Microsoft Office software.
Each profit center provided the stream of funds for the company to use when it expanded into other fields such as video games with the X-Box as well as fund large share repurchases and cash dividends.
The Role of a Profit Center Executive
A manager or executive in charge of a profit center is likely to face a much more difficult job than someone overseeing a division that is not classified as a profit center. The reason is simple. A profit center manager is going to have to both increase sales by generating additional revenue and decrease costs as a percentage of revenue, much like an entrepreneur would have to do in his or her own independent business. It's an easy to remember two lever principle I once wrote about on my personal blog: cash in and cash out.
Cost Centers vs. Profit Centers
A cost center manager, on the other hand, only has to worry about staying within budget. A cost center is a department that is important to the overall success of a company, but its contribution to revenues and profits can be only incrementally measured.
It's an area within a business that typically runs red ink in upfront losses but will result in a much richer company if managed correctly; think of the research division of a major pharmaceutical corporation that spends billions of dollars developing new drug treatments without selling a single pill for years.
If they discover a miracle drug that effectively cures cancer without any negative side effects, all those years of red ink would have been worth it. If the pipeline were to dry up and the cost center shut down, the company would soon find itself a shadow of its former self. Yet, it is a cost center, not a profit center, that is likely to find itself at the top of a list when it comes to recessionary layoffs.
Many businesses are tempted to treat all divisions as cost centers instead of profit centers. The legendary management consultant and thinker Peter Drucker originally created the term profit center in the 1940’s. He subsequently asserted that the term profit center is a misnomer that leads managers to focus on the wrong overall priorities, insisting instead that everything is a cost center. By focusing only on the absolute profit of a division, factors such as return on capital, opportunity cost, efficient use of resources, and relative returns are ignored to the detriment of the stockholder or owner. This can be a horrible mistake because if managers are rewarded simply on cutting costs, they will not make sufficient reinvestment in a business to grow profitably for the future.
Hence, you eventually end up with outdated equipment, facilities, and staff and your customers are likely to go elsewhere because their needs aren’t being met. A profit center approach, on the other hand, blends the need for current cash with the desire to grow earnings in the future, making a manager accountable for the long-term health of a business.
Investment Centers vs. Profit Centers
A closely related concept to a profit center is an investment center. Whereas a profit center simply measures the overall contribution of a division’s profitability to the parent corporation, an investment center measures all uses of capital against a theoretical required rate of return. Although the investment center approach is extremely useful in evaluating the overall profitability of a company as measured by return on capital deployed, it can be manipulated by managers who know how accounting rules work.
By simply modifying depreciation rates, for instance, they could increase the estimated return on invested capital. They could also change the so-called hurdle rate to a more easily attainable figure (the hurdle rate is a return a profit center or other division must earn in order to be considered a good investment for the company; in other words, it is a minimum acceptable rate of return).