PROFIT CENTER ACCOUNTING
by Bill Schoeffler and Catherine Oak
Is Personal Lines costing your agency money? When is it time to hire a new employee for Commercial Lines? Profit center accounting can help you to answer these and other questions.
Profit Center Accounting can help you make strategic management decisions by allowing a closer review of small portions to evaluate how each of these segments is performing. You can use the knowledge gained from this tool to allocate resources, especially personnel, among the centers. Profit centers can also stimulate healthy competition between each unit. We recommend that agencies do a thorough Profit Center review at least once a year.
Most agencies rely on a traditional P&L statement that reflects the various overall revenues and expenses and profit for the whole agency. However, these figures aren’t broken down into smaller segments or lines. This method provides no insight into the true profitability of individual lines of business, internal departments, branch offices, or even individual producers. This limits the information available to agency owners when making important management decisions. Using single department accounting, they might never understand the real issues, opportunities, and constraints that are hidden in the numbers.
Profit Center Accounting does take some time to set up and slows down accounting data entry a bit. Although your agency management system might not always accommodate analysis by profit centers, there are alternatives for these rare situations. You should also take care in setting up Profit Center Accounting because it would be cumbersome to revise an established system.
ESTABLISHING PROFIT CENTERS
So what are “Profit Centers” anyway? The first categories to consider 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 their revenue, but not expenses and profits by line. Departmental analysis will enable you to determine overstaffing, as well as the success of marketing campaigns easily.
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. It often makes sense to create a Profit Center for administration, as well.
For most accounting systems, you can easily establish Profit Centers 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. Break out each revenue and expense category for each of the defined Profit Centers. The goal is to have a separate financial statement for each center, as well as a consolidated financial statement for the agency. You can also use this approach for the balance sheet (if you’re a hard-core financial maven).
It’s usually best to do the adjustments while entering the data the first time. However, in some situations, you might find it easier to export the accounting data to an Excel spreadsheet to do the final calculations. The reason: The amount of manual calculations the bookkeeper has to do as they’re 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 doing them manually and then entering the numbers into the agency accounting software. The Excel spreadsheet allows the bookkeeper to preset the formulas; once the numbers are entered, Excel will allocate the expenses automatically based on the formulas set up.
MAKING PROPER ALLOCATIONS
If there’s a weak link in Profit Center Accounting, it lies with the allocation of income and expenses. When allocations are not assigned accurately, the results will be just as inaccurate (“garbage in, garbage out”). Management might easily make poor decisions based on interpreting bad data. The goal is to create an accurate, yet efficient, allocation process. Once you set up the structure for allocations, the process becomes easy, although it might be a little time consuming.
Break down income and expenses into two categories — direct and indirect. Direct income and expenses can be 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 clearly as a direct expense to the PL Profit Center, while the cost of office supplies or the bookkeeper would probably fall across several Profit Centers.
Commission income is almost always specified on the insurance company statements by line of business. If further refinement is required, you can obtain sub-producer codes by such categories as income by branch office. You can also break out Contingent income by line of business. Interest income is an indirect income source that can be allocated easily by pro-rating it according to agency bill premium volume.
You can allocate indirect expenses by premium volume, commissions, number of employees, number of accounts, or even time spent. After careful analysis, most of the time there’s one best approach; however, once in a while the choice is murky and might require a little finesse. It’s important to keep the process in perspective. Do not create a complex, time-consuming allocation system when a simple, fairly accurate approach will suffice and save time. For example, you can allocate telephone expenses either by commissions or by employee. If you create a more complex formula, 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% of total revenue.
Because the largest expense in all agencies is employee (including owners and producers) compensation, accuracy counts here. Service staff is often a direct expense since an agency might have two PL CSRs and three CL CSRs. For service employees who split their time between roles, the salary cost should usually be allocated by time. Producer commissions are direct expenses. However, 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 for employee compensation.
Charge back administrative expenses to each department. Allocate salaries for accounting and the receptionist to each department by a ratio of commissions, number of accounts, or time spent. If your agency has an HR person or an IT person, split expenses for these personnel 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 usually allocated either by 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. Be sure to use the “full-time equivalent” number of employees, not the actual count of bodies. Someone who splits their time with 75% in one department and 25% in another, counts as 0.75 for the first department and 0.25 for the second department.
Allocate office supplies, telephone, and postage by using a ratio of commissions or number of accounts. However, in some agencies this approach 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. In these cases, a weighting factor on top of the ratio of commissions can be helpful.
Keep in mind that there are no hard-set rules for doing allocations, since every agency is unique. You need to be accurate, yet as elegant and simple as possible. Review the allocations after the first six months of incorporating Profit Center accounting and then again in another six months. An annual review of allocations after the first year should be enough to make sure that the accounting is fair and accurate.
It’s essential to get department managers involved in the process. This way the managers become both responsible and accountable for the profitability of their department. Tie bonuses to Profit Center performance.
HOW TO USE IT
Once all the income and expenses are 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 results 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 your gut feeling. But don’t be surprised if the numbers contradict intuitive expectations. Management can now get clear answers to “what if?” scenarios. For example, you can use Profit Center accounting to answer such questions as:
- 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. However, the use of Profit Center accounting will broaden your vision of what questions to ask and where to find the answers. Asking the right questions and then getting answers plays a fundamental role in management. A good understanding of income flow, cost structure, and the profit potential within your business is critical to establishing and implementing effective strategies.
Having a grasp of the numbers allows you to determine the best path for your agency. Should the firm purchase a book of business? How much should you budget for the marketing expenses of a new niche program? When can the firm hire additional staff?
You can’t know which direction is forward unless you know the direction of the path you’ve already covered.
A PARTING THOUGHT
Profit Center Accounting requires a certain level of sophistication to establish and maintain. It also requires commitment and discipline to make the results meaningful. However, this approach can make the difference between looking at a balance in a checkbook and reviewing a detailed income and expense statement. Being informed will help you to manage more effectively, because you have the tools to know what to change. It will also help you raise your agency to the next level.
Bill Schoeffler and Catherine Oak, CIC, AAI, are partners in the consulting firm, Oak & Associates, based in Northern California. The firm specializes in financial and management consulting for independent insurance agencies, including valuations, mergers acquisitions, clusters, sales and marketing planning as well as perpetuation planning. They can be reached at (707) 936-6565 or by e-mail at [email protected].
SAMPLE PROFIT CENTER INCOME & EXPENSE FINANCIAL TABLE
For illustration purposes, here’s a sample agency with $1 million in total commissions: $600,000 from Commercial Lines and $400,000 from Personal Lines.
The agency has one owner/producer, one CL producer, two CL CSRs at $45,000 each, two full-time PL CSRs at $40,000 each, one person splits their time equally as PL CSR and receptionist at $35,000 in salary, and one bookkeeper at $50,000 annually. The owner gets a $50,000 management fee. The owner and producer are both paid 35% for their Commercial Lines book (nothing for Personal Lines). Both the bookkeeper and part-time receptionist spend about 50% of their time for each department (PL & CL).
The table shows one way of allocating income and expenses. The formula used for allocations will vary for each agency. To keep this model simple, not all expenses were shown.
| | TOTAL AGENCY | COMM. LINES | PERSONAL LINES | COMMENTS |
| Percent of Commissions | 100% | 60% | 40% | |
| Number (and percent) of Employees | 8.00 (100%) | 4.75 (60%) The percentage is rounded | 3.25 (40%) The percentage is rounded | Remember to split the time for the bookkeeper and receptionist |
| | | | | |
| Agency Bill income | $550,000 | $400,000 | $150,000 | Use Actual numbers |
| Direct Bill Income | $450,000 | $200,000 | $250,000 | Use Actual Numbers |
| Total Income | $1, 000,000 | $600,000 | $400,000 | Use Actual numbers |
| | | | | |
| Management Fee | $50,000 | $25,000 | $25,000 | Use time spent |
| Producer Commissions | $210,000 | $210,000 | $0 | Use Actual Numbers |
| Office Staff Compensation | $255,000 | $123,750 | $131,250 | Use Actual Numbers |
| Rent & Utilities | $42,000 | $25,200 | $16,800 | Use Ratio of Employees |
| Telephone | $18,000 | $10,800 | $7,200 | Used Ratio of Commission |
| Travel & Entertainment | |
|