Understanding a Profit Center
A Basic Understanding of the Business Term Profit Center
Way back in the 19th century, an Italian economist coined what became known as the "Pareto principle." Vilfredo Pareto believed that 80% of the effects in any given scenario are the result of just 20% of the causes. When applied to the world of business, this means that 80% of a company's profits can be attributed to just 20% of the company's clients, operations, or products. As businesses sought to capitalize on this theory, profit centers became a central tenet of their strategy.
The profit center is the segment of the business that management depends on for its bottom line profit. Knowing how to accurately identify one's profit centers, and how to leverage those profit centers to bolster other aspects of the business, can help a company achieve long-term success.
A Profit Center Example
As an example, let's look at Microsoft. Microsoft has thousands of products that range from video game consoles to search engines, but the major profit centers are the Windows operating system and the Microsoft Office software. The company depends on the profits from those software products to fund new products and ventures.
As Microsoft prepared to launch the original Xbox console back in 2001, the company depended on its software sales as it invested in game development and the production of hundreds of thousands of consoles. The profit centers ensured that Microsoft stayed afloat as it poured money into this new investment. The risk paid off, and the Xbox has been a hit ever since, but even if the Xbox flopped, the profit centers would have allowed Microsoft to survive the failed venture.
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: the entire company depends on them. A profit center manager is going to have to both increase sales by generating additional revenue and decrease costs as a percentage of revenue. Failure to do so will have a disproportionate effect on the entire company, compared to managers in other areas.
Cost Centers vs. Profit Centers
A cost center manager, on the other hand, only has to worry about staying within the budget. A cost center can be considered the opposite of a profit center. It's a department that is important to the overall success of a company, but its positive contribution to revenues and profits can be only incrementally measured—if there's anything to measure at all. More often than not, a company's cost center runs red ink in upfront losses. However, cost center operations will result in a much richer company, if managed correctly.
As an example, think of the research division of a major pharmaceutical corporation. The company spends billions of dollars developing drug treatments without selling a single pill for years. If they make a breakthrough and create a brand new drug, all those years of red ink would have been worth it. If management decided to shut down the cost center, the company would lose a valuable portion of its operations. Yet, when money is tight and management is worried about costs, cost centers usually find themselves on the chopping block.
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. The investment center approach is useful in evaluating the overall profitability of a company, as measured by return on capital deployed.
However, investment center metrics can be manipulated by managers who know how to bend accounting rules. 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—the minimum acceptable rate of return—to a more easily attainable figure just before reporting the numbers.
Profit Center Criticism From its Founder
While the Pareto principle has been around since the late 1800s, the legendary management consultant Peter Drucker created the term "profit center" in the 1940s. He subsequently regretted his earlier writings on profit centers. He asserted that a profit center mentality leads managers to focus on the wrong overall priorities.
He insisted that everything is a cost center, instead. By focusing only on the absolute profit of a division—as profit center mentality does—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 for cutting costs, they will not make sufficient reinvestment in the business to grow profitably for the future. Hence, you eventually end up with outdated or subpar equipment, facilities, and staff.
Still, there are benefits to a profit center approach. When applied correctly, it 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.