Your son is doing a terrific job. Heis turning out a high-quality floor buffing machine while holding theline on operating costs. Thebuffers command a premiumprice. By raising the price even higherand by throwing in a few free bufferpads and some noor wax with each machine sale, he confidently predicts thathis division will score its most profitableyear ever.
The idea of freebies, though, doesn’tsit well with the manager responsiblefor the manufacture and sale of yourbuffer pads. He has no chance of enjoying a record year if his division givesaway pads to promote machine sales. Infact, his agenda couldn’t bemore different than yourson’s. He knows he can movemore pads out the door ifyour son would sell more machines at lower prices, maximizing market share ratherthan pro~it. Indeed, he maintains that the company is better off if it cuts the price ofthe machines while his division simultaneously raisesthepriceofpads.
Profit centers can be an excellent tool to professionalizethe family business, managethe company, and maximizerevenue and profit. But unless you select the properprofitcenters,yourcompanymay suffer the same sharpconflicts that Acme Buffersexperienced. And if battles among managers aren’t bad enough,the failure to select the right profit centers can also lead to confused market-ing strategies and distorted resource allocation.
How do you create profit centers?Should they mirror your organizationalset up for operations and control?
The traditional accounting approachis to establish separate profit centersfor each product or service line. AsAcme discovered, however, this plancan cause conflict and confusionthroughout the company.
There are alternative ways of organizing pro~t centers: by major customergroups or market segments or even bydistribution systems. The key questionsto ask yourself are:
How does the price or fee for a particular product affect demand for theitem? In addition, how does it affect theprices of the company’s other products?
What is the best way to coordinate theprices of various products to achievemaximum revenue and profit?
If an examination of the goods or services offered by your company showsthem to be independent of each other–that is, their price and volumes have nocross-effect on each other then itmakes sense to establish profit centersstrictly by product line. If you manufacture basketballs and ski equipment,for instance, there is little risk that thepricing or marketing of one would affectthe other.
Products and services, though, arenot always independent. Often they arerelated. Complementary goods, such asAcme’s noor buffers, pads, and cleaningchemicals, are so interrelated that theprice and sales volume of one affectsthe price and sales of others. Raise theprice of one item–say, floor buffers–and not only will you sell less of thatitem, you’ll discover that thesales of your other items–pads and chemicals–willalso decline.
A company’s products canalso compete against eachother. Beef and chicken arecompetitive. Higher beefprices push beef sales down.People eat more chicken, andchicken prices start to rise. When products are eithercomplementary or in competition, organizing profitcenters along other linesmakes more sense. The solution for our buffer com-pany may be to turn its entire”floor-care system” into aprofit center. Retain individual profit and loss statementsand balance sheets for eachsegment as internal measures of efficiency; however, be sure toconsider the impact of a change in theprice and volume of one of the complementary products on the price and volume of other products.
By trial and error, you should be ableto come up with the right level of complementary prices for all three productlines that maximizes revenue and profitfor the entire company.
Organizing profit centers aroundmarket segments or major customergroups can also maximize overall profit.You may find that it pays to set up twoprofit centers: one for direct sales tohospitals and educational institutions,which balk at high initial machine costsbut use lots of pads; and another forsales to maintenance companies thatservice commercial office buildings,where the high cost of the machine isaccepted by the building owner as longas he is able to keep his routine maintenance costs low.
Yet another way to organize profitcenters is by distribution systems instead of product lines. Set productprices to maximize profit within theirrespective distribution systems. Acme,for example, would develop a secondbuffing machine that it would sell andmarket in a different way. This secondbuffer would satisfy your son’s desire toraise the price.
Soup up the existing model, addingenough bells and whistles to justify amuch higher price tag, and sell itthrough upscale home catalogues. Thisdistribution system will enable you toreach a different market without affecting your pricing or sales volume to ex-isting customers.
Naturally, you will have to devise acompensation system that rewardsmanagers for placing the company’soverall performance above that of theirown divisions. But that organizationalchore should be a pleasant one.
Daniel A. Nimer is president ofthe DNAGroup Inc., a management consultingfirm in Northbrook, Illinois.