Is personal lines costing the agency money? How profitable is that new program business? What would happen to the bottom line if employee benefits sales increased by 25 percent? When is it time to hire a new employee for commercial lines? These and other questions can be answered by establishing Profit Center Accounting.
Profit Center Accounting is a management tool to assist with strategic decisions. The concept is to allow a closer review of small portions of the overall agency to evaluate how each of these segments are performing. Using the knowledge gained from this tool, resources, especially personnel, can be optimally allocated among the centers. Profit centers may stimulate healthy competition between each unit.
Agencies should perform at least a thorough annual review of the firm using profit centers.
Most agencies rely on the traditional profit and loss statement that reflect the overall revenues and 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?” The first categories to consider 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, 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 situations as well as the success of a marketing campaign can be easily determined.
Profit Centers by location are also 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. 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.
For most accounting systems, Profit Centers can easily be established by creating subcategory codes. For example, commission income might be category 4000. Personal lines could be set up as 4010, 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 has 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 (but that should be saved for the serious financial geeks).
Usually, it is best to make adjustments while entering the data the first time. However, for some situations the agency might find it easier to export the accounting data to an Excel spreadsheet to do final calculations. This is due to the amount of manual calculations the bookkeeper has when entering indirect expenses into 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 formulas, enter the numbers, and let Excel automatically allocate the expenses based on the formulas.
Making Proper Allocations
If there is a weak link in Profit Center Accounting, it’s in the allocation of income and expenses. When allocations are not accurately assigned, the results will be inaccurate and misleading. Management could make poor decisions based on 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.
Income and expenses can be broken down into two categories — direct and indirect. Direct income and expenses can be identified as belonging 100 percent to a specified Profit Center. 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 insurance company statements by line of business. Subproducer codes can be obtained if refinement is required, such as income by branch office. Contingent income is also often broken down by line of business. Interest income is an indirect income source, and it can easily be allocated by prorating it by agency bill premium volume. Today, there is very little interest income, so there is little allocating needed.
Indirect expenses can be allocated by commission volume, commissions, number of employees, number of accounts or time spent. After careful analysis, most of the time there is one best approach. But sometimes 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 time consuming when a simple approach will do.
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, because the overall cost for telephone expenses is usually less than 2 percent of total revenue.
The biggest expense in all agencies is employee compensation, (including owners and producers), so accuracy counts with these expenses. Service staff is often a direct expense because an agency might have two PL CSRs and three CL CSRs. For 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 they handle 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 and the receptionist 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 cost 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 number of employees. Use the “full-time equivalent” number of employees, not the actual body count. Someone who splits his or her time at the rate of 75 percent in one department and 25 percent 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 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 amount 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 be helpful in those cases.
There are no hard-set rules for how allocations are done, because 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 ensure the accounting is fair and accurate.
It is also important to get department managers involved in the process. This way, managers are both responsible and accountable for the profitability of their department. Bonuses can be tied to Profit Center performance.
For a sample of allocating expenses for Profit Center Accounting, contact Catherine Oak with Oak & Associates at email@example.com or 707-935-6565.
A Parting Thought
Profit Center Accounting requires a certain level of sophistication to establish and maintain. It also requires some commitment and discipline to make the results meaningful. It is however, the difference between looking at a balance in a checkbook and looking at a detailed income and expense statement. Being informed will help make management more effective, because it will have the tools to know what to change. It also will assist in bringing the agency to the next level.
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