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No To Profit Centers

Dear Dave
One of our senior project managers attended a seminar you presented in Las Vegas earlier this year on the subject of financial management geared for engineers. He gained quite a bit from the program, and we have since adopted and implemented a number of your ideas and initiatives at our firm. One thing I don’t understand and continue to struggle with, however, is the fact that at the seminar you reportedly advised against establishing profit centers within an engineering firm? Our project manager was not real clear on this. Could you explain your advice?

Dear TC
Profit centers are accounting mechanisms designed with the noblest of intentions to track the financial results of the company back to the operating component pieces of the firm’s table of organization. Their weakness is that profit centers can become administratively intensive to operate, can foment counterproductive levels of internal competition between groups causing decisions to be made in the interest of a group at the expense of the firm, and are highly argumentative as to the assumptions underlying how they will operate.

So, for example, let’s say that an engineering firm has three internal operating departments and a branch office each doing work for clients and generating income, for a total of four profit centers. In addition to the four profit centers, the firm also has a central administrative pool consisting of corporate-wide management staff, marketing, accounting, computer, and human relations functions each to varying degrees servicing the needs of the four profit centers.

In classic profit center accounting, each month, the income and expenses identified as being specifically associated with each of the three departments and the branch would be directly assigned to each of the four profit centers. Next, the cost of the central administrative staff, along with all other costs of a common nature to operate the company not otherwise directly attributable to any one project center, are pooled and zeroed out by allocating the shared cost pool between the four profit centers. This allocation can be done in any number of ways, but a typical method used would be to spread the pooled cost among the four profit centers based on the percent of the payroll of each profit center as a percent of the combined total payroll of all four profit centers. The result being that the company pooled common cost has been now allocated out to the four profit centers, and the sum of profits and losses of the four profit centers now equals the profit and loss of the entire company. So far, so good.

The first problem with profit centers often occurs in the form of a barrage of objections by those responsibly in charge of each profit center about how patently unfair is the method used to allocate the pooled common cost. One profit center or the other will strenuously complain that they don’t derive benefit from central marketing, or they do their own recruiting, or they send out their own invoices, etc. No matter how much time and energy you put into discussing and massaging the allocation, the profit centers will never be happy and will always point to the inequity of the entire system as a reason why they should not bear responsibility and be held accountable for the outcome you’re trying to monitor.

Next point, in many firms projects are shared (or could be, or should be shared) among multiple departments or even offices. Profit center accounting denominates financial performance vertically, by profit center, not across-the-board horizontally, by project. If Department A calls on Department B to help with a project, Department A must either “pay” Department B for the time and effort they spend on Department A’s projects, or Department B must be allowed to transfer its cost while working on Department A’s projects to Department A. Like the method to allocate central overhead, arriving at a universally accepted method and rate at which to compensate for out-of-profit-center activity can be elusive. If not resolved, the tendency is for profit centers to either horde work or fail to share resources. Ultimate horror—one department hiring staff when another department is laying off staff that could be cross-trained and transferred. Or worse, the ideal person to work on a particular project is not used because that person is based in a different profit center and the accounting system would create a penalty.

Here’s a simpler, 3-point alternative system to track performance and assign accountability which avoids classic profit center pitfalls:

1) Each department or branch manager can and should be held to task for maintaining a targeted direct labor percentage rate for all staff assigned to their group. If they cannot keep resident staff adequately scheduled on projects within their own group, the manager must actively work with other departments or branches to lend out excess staff to other groups. Managers have a shared interest and get in the habit of routinely working together to keep all staff fully assigned. Goal-wise, as long as staff is assigned to work, it does not matter whether that work is inside or outside the home department.

2) Each department or branch manager should be accountable to an annual budget provided for any cost items over which they themselves have personal spending discretion. Since they cannot control corporate overhead, why make it an issue?

3) Each department or branch manager should be responsible for the entire financial performance of any project hosted by their group (even if it involves multiple departments or offices) measured by goals established for the gross margin of those projects (gross margin is billings minus direct labor and direct expenses, but before overhead). Since we are measuring financial performance on gross margin (before overhead) there is no need to allocate common corporate overhead. Since we are denominating by entire project, there is no need to share revenue or transfer expense among multiple departments or branches. If you host the project, you accept complete responsibility to manage the entire outcome, even if other profit centers participate.

Wahby and Associates