Proper Profit Center Accounting

Do owners really know which departments or lines of business are making money in their agency? What are small commercial accounts costing the agency? How can the agency make personal lines more profitable? When is it time to hire a new producer or account manager for commercial lines? What would it cost to set up a benefits department with experienced people to start rounding out the agency’s accounts?

These and other important questions can be answered by establishing good profit center accounting.

Profit center accounting is a tool for management to assist them in making strategic management decisions. The concept is to allow a closer review of small portions of the overall agency in order to evaluate how each of these segments is performing. Using the knowledge gained from this tool, resources, especially personnel, can be optimally allocated among the centers. Profit centers may also stimulate healthy competition between each department or unit.

Oak & Associates recommends that agencies perform a thorough review of the firm using profit centers at least annually as a minimum.

The Past Ways

Most agencies rely on the traditional profit and loss statement that reflects the various overall revenues, expenses and profit for the whole agency. However, these figures are not broken down into smaller segments or lines. This traditional method provides no insight into the true profitability of individual lines of business, internal departments, branch offices, or even individual producers.

The lack of profit centers limits the information available to agency owners when making important management decisions. The real issues, opportunities and constraints are hidden in the numbers and might never be understood due to the limitation of using single department accounting.

Establishing Profit Centers

So, what are “profit centers” anyway? The first categories to be considered should be by line of business (personal lines, commercial lines, benefits, life, etc.). Agencies with a small commercial department or a VIP personal lines department should have separate profit centers for these departments, as well. Non-commission income, such as premium finance or contingent income, should also be segregated. This will allow management to quickly see revenue AND expenses AND profit by line of business.

Most firms know the overall agency revenue, but not the expenses and profits by line of business. Overstaffing or understaffing situations can be easily determined relative to sales and service staff needed.

Profit centers by location are also very useful. Location “A” might be increasing revenue over time, while location “B” has stagnant growth and increasing expenses.

Management needs to have accurate information to make effective decisions. In some cases, it might make sense to assign profit centers to each producer or by producer teams. This way, producers can be held accountable or rewarded for the profitability or lack thereof in their department. Keep in mind that it often makes sense to create a profit center for administration, as well.

Use Sub-category Codes

For most accounting systems, profit centers can easily be established by creating sub-category codes. For example, commission income might be category 4000. Personal lines could be set up as 4010, and commercial lines could be 4020, etc. The coding might be a suffix, such as 6200-100 in some cases, or for QuickBooks, it would be unique classes. Each revenue and expense category should be broken down by each of the defined profit centers. When done properly, management can have a separate financial statement for each of the established profit centers, as well as a consolidated financial statement for the agency overall. The same approach can be used for the balance sheet, as well!

For some situations, the agency might find it easier to export the accounting data to an Excel spreadsheet to do the final calculations. The reason for this is due to the number of manual calculations the bookkeeper has to do as she/he is entering the indirect expenses in the system. For instance, if the agency has a complex formula to allocate expenses, the bookkeeper might find it easier to perform those calculations in Excel rather than manually doing it and then entering the numbers into the agency accounting software. The Excel spreadsheet allows the bookkeeper/accounting manager to preset the formulas, and once the numbers are entered, Excel will automatically allocate the expenses based on the formulas that are set up.

Making Proper Allocations

If there is a weak link in profit center accounting, it is in the proper allocation of income and expenses. When allocations are not accurately assigned, the results will not just be inaccurate but can be misleading. Management could easily make poor decisions based on interpreting bad data. The goal is to create an accurate yet efficient allocation process. Once the structure for allocations is established, the process is easy, albeit a little time-consuming.

This is the best way to do it. Income and expenses can be broken down into two categories — direct and indirect. Direct income and expenses can be clearly identified as belonging 100% to a specified profit center. In contrast, indirect income and expenses can be assigned to multiple profit centers. For example, the salary for a personal lines CSR is easily identified as a direct expense to the PL profit center, while the cost of office supplies or the bookkeeper would likely fall across several profit centers.

Commission income is usually specified on the insurance company statements by line of business. Sub producer codes can be obtained if further refinement is required, such as income by branch office. Contingent income is also often broken down by line of business.

Indirect expenses can be allocated by commission volume, commissions, number of employees, number of accounts, or even time spent. After careful analysis, most of the time there is one best approach, but once in a while, the choice is murky and may require a little finesse.

It is important to keep the whole process in perspective. Do not create a very complex allocation system that is very time-consuming when a simple approach that is fairly accurate will do and save lots of time. For example, telephone expenses can be allocated by commissions or by employee. If a more complex formula is created, the time spent figuring the allocation might not be worth the gain in accuracy since the overall cost for telephone expenses is usually less than 2% of total revenue! It is easy to allocate the cell phone costs to producers and which lines of business they sell.

Get Compensation Expense Allocations Right!

The biggest expense in all agencies is employee compensation (including owners and producers), so accuracy really counts with these expenses. Service staff is often a direct expense since an agency might have two PL CSRs and three CL CSRs. For those service employees that split their time between roles, the salary costs are often best allocated by time. Producer commissions are direct expenses, but if a producer is paid a salary and handles multiple lines, the salary can be allocated by a ratio of commissions by line handled by the producer. Employee benefits and payroll taxes should match the same allocation approaches used above for property/casualty employee compensation.

Administration expenses need to be charged back to each department. The salaries for accounting personnel, the receptionist, data entry people, and clerical staff can be allocated to each department by a ratio of commissions, number of accounts, or time spent. If the firm has an HR person or an IT person, expenses for those personnel are split based on a ratio of employees in each profit center. Office managers and owners paid a management fee need to assess their time and allocate their costs proportionally.

Indirect overhead expenses are typically allocated by either a ratio of commissions or by a ratio of employees in that profit center. Rent and automation expenses are good examples of expenses that are often allocated by the number of employees. Keep in mind to use the “full-time equivalent” number of employees, not the actual count of bodies. Someone who splits his or her time at the rate of 75% in one department and 25% in another, counts as 0.75 for the first department and 0.25 for the second department.

Office supplies, telephone and postage might be allocated by using a ratio of commissions or number of accounts. However, that approach in some agencies might not be appropriate because one line of business might not use the same number of supplies or postage or have phone charges in the same proportion as the other lines. A weighting factor on top of the ratio of commissions can prove to be helpful in those cases.

Keep in mind there are no hard-set rules for how allocations are done since every agency is unique. Again, there is a need to be accurate yet as elegant and simple as possible. Review the allocations after the first six months after the firm incorporates profit center accounting and then again in another six months. An annual review of allocations after the first year is adequate to make sure the accounting is fair and accurate.

It is also very important to get department managers involved in the process. This way, the managers are both responsible and accountable for the profitability of their department. Bonuses can be tied to profit center performance.

How to Use It

Once all the income and expenses are properly allocated to the various profit centers, then proper management can begin. Management can now run reports to determine the profitability of each business segment. A quick review of the results will indicate if that new program the agency has been working hard on is paying off. For example, is personal lines just an accommodation, or is it a moneymaking department?

In some cases, the information will confirm a gut feeling. But don’t be surprised if the numbers contradict intuitive expectations. Management can now get clear answers to questions posed in “what if” scenarios.

Wouldn’t it be great to know the answers to the following questions? Was the direct mail program or new ad campaign for the personal lines department profitable? Are the perquisites paid to the commercial lines producers cost-effective? Is the staffing for the service department adequate? How would it impact the bottom line if the firm added a producer paid on a commission basis which brought in $75,000 in commission revenue the first year? Should the agency purchase a book of business?

Summary

Asking the right questions and then getting answers is a fundamental part of management. A good understanding of income flow, cost structure, and the profit potential within a business is critical to establishing and implementing effective strategies. One cannot know which direction is forward unless the direction of the path already covered is known.

Profit center accounting does require a certain level of sophistication to establish and maintain. It also requires some commitment and discipline to make the results meaningful.

Being informed will help make management more effective because it has the tools to know what to change. It also will assist in bringing the agency to the next level.