Profit Center Accounting

Is personal lines costing the agency money? How profitable is that new program business the agency is promoting? 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 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 unit. Oak & Associates recommends that agencies perform at least an annual thorough review of the firm using profit centers.

Most agencies rely on the traditional profit and loss statement that reflect 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.

Profit Center Accounting does take some time to set up and it does slow down accounting data entry a bit. Occasionally, the agency management system might not accommodate splitting up the accounting by profit centers, however there are alternatives for these rare situations. Also, care must be taken to set up the best system for the agency and management, since it would be rather cumbersome to revise an established system.

Estblishing profit centers
So, what are “profit centers” anyway? The first categories to be considered should be by line of business (personal lines, commercial lines, etc.). Agencies with a small commercial department or a VIP personal lines department should have separate profit centers for these departments as well. This will allow management to quickly see revenue and expenses and profit by line of business. Most firms know the revenue, but not the expenses and profits by line. Overstaffing situations as well as the success of a marketing campaign can be easily determined.

Profit centers by location are also very useful. Location A might be increasing revenue, 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 employee 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 sub category 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 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 (but that should be saved for the serious financial geeks).

Usually it is best to do the 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 the final calculations. The reasoning for this is due to the amount of manual calculations the bookkeeper has to do as she 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 then manually doing it and then entering the numbers into the agency accounting software. The Excel spreadsheet allows the bookkeeper to preset the formulas and once the numbers are entered, Excel will automatically allocate the expenses based on the formulas set up.

Making proper allocations
If there is a weak link in Profit Center Accounting, it is in the allocation of income and expenses. When allocations are not accurately assigned, the results will be just as inaccurate. 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.

Income and expenses can be broken down into two categories—direct and indirect.

Direct income and expenses can be clearly identified as belonging 100 percent 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 personal lines profit center, while the cost of office supplies or the bookkeeper would likely fall across several profit centers.

Commission income is almost 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. Interest income is an indirect income source and it can easily be allocated by prorating it by agency bill premium volume.

Indirect expenses can be allocated by premium 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 percent of total revenue.

The biggest expense in all agencies is employee (including owners and producers) compensation, so accuracy really counts with these expenses. Service staff is often a direct expense since an agency might have two personal lines CSRs and three commercial lines CSRs.

For those service employees that split their time between roles, the salary cost should usually be 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 allocate by a ratio of commissions by line handled by the producer. Employee benefits and payroll taxes should match the same allocation approaches used for 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. 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 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 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 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 prove to be helpful in those cases.

Keep in mind there is 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 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 really 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, the fun can begin. Management can now run reports to determine the profitability of each business segment. A quick review of the result will indicate if that new program the agency has been working hard on is paying off. Is personal lines just an accommodation or is it a moneymaking department?

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

How useful is it to know the answers to the following questions?

How would it impact the bottom line if the firm added a producer paid on a commission basis who brought in $100,000 in commission revenue the first year?

Was the direct mail program for the personal lines department profitable?

Are the perquisites paid to the commercial lines producer cost effective?

Is the staffing for the service department adequate?

What is the spread for each department? (Spread is revenue per employee minus average compensation costs per employee).

Analyzing a single set of profit center financials might not answer all of these questions, but the use of profit center accounting will broaden the vision of what questions need to be asked and where the answers might reside. 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.

Having a grasp of the numbers allows managers to determine the best path for their firm. Should the agency purchase a book of business? How much should be budgeted for marketing expenses for a new niche program? When can the firm hire additional staff?

One cannot know which direction is forward unless the direction of the path already covered is known.

A parting thought
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. 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 has the tools to know what to change. It also will assist in bringing the agency to the next level.

Bill Schoeffler and Catherine Oak are partners in the international consulting firm, Oak & Associates. The firm specializes in financial and management consulting for independent insurance agents and brokers, including valuations, mergers acquisitions, clusters, sales and marketing planning as well as perpetuation planning. They can be reached at (707) 935-6565, by e-mail at bill@oakandassociates.com, or visit www.oakandassociates.com.

Topics Agencies Profit Loss