Profit Center Limitations Kenneth Merchant and Tatiana Sandino summarize clearly some of the potential limitations of profit center evaluation in the article, “Four Options for Measuring Value Creation” (Journal of Accountancy, August 2009, pp. 34–37). While profit centers are commonly used, these limitations are well known. Here are two of the most prominent.
1. Profit is a measure of past performance and not a measure of past or future value creation; that is, profit does not directly measure the improvement or decline in the market value of the company. The value of a public or privately held company can be measured in a variety of ways (see Chapter 20).
2. Profit as determined by U.S.-based generally accepted accounting principles (GAAP) is conservatively biased; for example, GAAP tends to use valuations based on purchase cost rather than current market values (note the section in this chapter in which we discuss international financial reporting standards [IFRS], which permit market value accounting in some situations where this treatment is not permitted under GAAP).
Merchant and Sandino propose four approaches to improving the profit center approach for strategic performance measurement:
1. Use market measures of value creation, such as stock price among others.
2. Use non-GAAP alternative measures of profit that reduce the conservative bias. Some of these measures, such as EVA®, are explained in Chapter 19.
3. Use a measure of profit that extends beyond the usual quarterly or annual statements; instead, look for long-term profit performance over 3 to 6 years or more.
4. Use a combination of measures. The balanced scorecard is one example of this approach.
Required
1. Do you agree with Merchant and Sandino’s assessment of the limitations of profit center measurement? Explain briefly.
2. Do you think the authors’ proposals for improvement are practical and potentially effective?
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