"Never spend your money before you have it."
- Thomas Jefferson, 3rd president of the USA (1801 to 1809)

Recall that profit refers to the positive difference between a firm’s total revenues and its total costs for any given period of time. Revenues are the inflows of money, usually from the sale of products. Costs are the outflows of money, to finance production and business activities. By contrast, if costs are greater than revenues, then the organization declares a loss. Most businesses will aim to provide goods and services (to satisfy their customers’ needs and wants) at a profit to ensure that they earn a return on their investment.

The role of profit in business activity

Although not explicitly mentioned in the IB Business Management syllabus, the role of profit is an important one for most businesses, which is why many organization set up profit centres. The functions of profit for businesses and their owners include:

• Profit acts as an incentive to produce. The profit motive is probably the key driving force for most business transactions.

• It acts as the reward for risk takers engaged in business activity.

• It encourages invention and innovation. New technological ideas and processes that cut costs of production will result in higher profits.

• Profit acts as an indicator of growth (or decline). Hence, it signals to the owners and investors of a business to switch from low profitability to high-profitability business activities.

• Being an internal source of finance and used to fund the growth of a business.

Businesses must make profits in order to survive in the long run. Even for non-profit organizations it is important to make a surplus (revenues exceeding costs). The difference between profit and surplus is that any surplus generated is all ploughed back into the business, rather than having some of it being distributed to its owners (as in the case of profits).

The roles of cost and profit centres can be remembered by the acronym MAMA:

• Monitoring and control – Organizations that use cost and profit centres do so in order to have better control over the different parts of their operations. Cost and profit centres enable large organizations in particular to monitor and control costs and revenues more effectively. Data from cost and profit centres of the business enable benchmarking to take place, i.e. comparing the financial performances of  the various divisions of the business to assess their financial efficiency. This monitoring and control of individual parts of the organization can help improve the overall financial efficiency in the business.

• Autonomy – Budget holders are empowered to make autonomous decisions for their respective cost and profit centres. The quality of the decisions made is improved as the budget holders are more aware of the realities and needs of the department. The operational decisions can be taken quickly, without have to refer to or get permission from head office. The speed of decision making also improves as a result.

• Motivating – Empowering budget holders to be in charge of cost and profit centres also serves to motivate these people to make better decisions for the organization. The organization can reward managers who operate efficiently and control their operating costs, and managers of profit centres who generate high levels of revenue and profits.

• Accountability – The use of cost and profit centres makes managers and budget holders accountable for their designated responsibilities. They are held accountable for all costs incurred by the centre (such as a subsidiary of a larger company) and their ability to control these costs. Similarly, managers of profit centres are accountable for the amount of revenue and profit made.

Ultimately, this means that cost and profit centres enable a business to operate more effectively and to make more informed decisions. For example, having accurate financial information about the costs and revenues of the different parts of a business can assist managers in deciding whether to continue or discontinue producing a particular good or service. In theory, a division of the business with the most significant costs and is the least profitable can be discontinued, in favour of allowing resources to be available for new products that are more profitable for the organization.

However, there are some limitations of using cost and profit centres:

• Unhealthy competition – Cost and profit centres can cause unhealthy and negative competition between different departments of an organization. This undesirable outcome may include different managers hiding of information and being uncooperative, which essentially hinders the organization’s ability to reach its goals.

• Loss of control – Senior executives may lose some degree of control as the managers of cost and profit centres are empowered to oversee the operational costs and/or revenues of their departments. The senior executives do not have as much personal knowledge of the operations at each centre.

• Subjectivity – Organizations that use cost and profit centres need to allocate the firm’s fixed costs between the various centres. However, doing so is somewhat subjective, e.g. how much of the rent should the finance, marketing, human resources and operations departments pay? The ambiguity can cause arguments and conflict between the staff.

• Short-termism – Creating cost and profit centres can encourage managers to take a short-term approach to their operations, at the expense of long-term profits. For example, in order to control costs and to maximise profit in the short-term, managers may neglect spending on training and development of human resources, maintenance of capital equipment, and research and development.

 Watch this 6-minute video clip to recap your understanding of the differences between cost and profit centres, and their roles in business organizations: