Organizations rely on a variety of different metrics to make short-term and long-term decisions. Cost centers and profit centers often produce this information. These centers play a central role in identifying where businesses can reduce costs and what strategies are profitable or unprofitable to turn a profit.
In this article, we discuss what a cost center and a profit center are, how they function in a business and how to measure the performance of each.
Contents
What is a cost center?
A cost center or cost center also called a revenue center, is a group or department within a company that performs functions that assist business operations but do not generate revenue directly.
The cost center determines its costs and creates ways to reduce those costs. Cost centers are valuable by indirectly increasing the company’s ability to profit by increasing:
- Operational efficiency
- Customer service
- Product value
- Brand awareness
- Legal compliance
- Building maintenance
Cost center type
Cost centers can take several forms, including:
- Production cost centers: These centers revolve around production and manufacturing and can include departments within a production facility, such as assembly and product development areas.
- Service cost centers: These cost centers include departments or groups that provide support services to the organization, such as maintenance and cleaning personnel, customer service, and quality control.
- Administration and sales expense centers: These centers incorporate departments or groups that are concerned with business or office administration and product sales.
Examples of cost centers include:
- Human Resources
- Accountancy
- Marketing
- IT Department
- Law Department
- Quality control
The cost center manager does not make company-wide financial decisions, such as setting prices or adding departments. Their role involves keeping departmental spending on or under budget.
Cost center performance
Cost center performance is measured by determining the cost variance. This involves comparing the standard cost and standard quantity of a product — a predetermined amount determined by market analysis and historical data — versus the actual cost and quantity required to produce a product.
Cost centers use these numbers to analyze their processes, including:
- Ordering materials and spare parts
- Determine workforce needs
- Identify inefficiencies
- Re-evaluate price and quantity targets
The cost variance includes the price variance and the quantity variance.
Total cost variance = price variance + quantity variance
Example:
Consider a clothing manufacturer. The company budgeted $5 to manufacture its most popular shirt. This means the standard fee is $5. The target quantity—or standard quantity—to produce T-shirts is 1,000 yards of fabric per year. In one year, the company used 1,100 yards of fabric and produced shirts for $4 each.
To determine the total cost variance, first determine the price variance.
Price variance = actual quantity x (actual price – standard price)
PV = 1,100 x ($4 – $5)
PV = 1,100 x (-1)
PV = -$1,100
The actual price is less than the standard price, meaning it is a profitable $1,100 price variant. A negative number indicates that the company is spending less than anticipated.
Next, determine the quantity variance:
Quantity variance = standard price x (actual quantity – standard quantity)
QV = $5 x (1,100 – 1,000)
QV = $5 x (100)
QV = $500
The actual quantity is more than the standard quantity, meaning this is an unfavorable quantity variance of $500. A positive number indicates how much the company used in excess of the targeted amount.
Remember the formula for the total cost variance: TCV = price variance + quantity variance
For this example, total cost variance = (-$1,100) + $500. This becomes $500 – $1,100, which is -$600.
Again, a negative number indicates the company is under budget in this area. This is a favorable total cost variance of $600 for the cost center.
What is a profit center?
A profit center or profit center is a division or department of a company that generates revenue and profits directly. It is often managed as a separate business, responsible for minimizing costs and maximizing profits.
Profit centers help companies by:
- Make money
- Calculating return on investment
- Providing information for financial decisions
- Budgeting
Type of profit center
Profit centers vary in how independently they are run from an organization. The types of profit centers include:
- Departments within the organization: A profit center can be any internal department that generates revenue, including a sales department.
- Independent entity: A profit center can also be a separate, stand-alone business that generates revenue for the organization, such as a repair shop in a bicycle shop.
Profit center performance
You can measure profit center performance by comparing budgeted costs with actual costs.
For example, consider a cell phone service provider who budgets 30,000,000 in running costs for a refurbished cell phone and accessory store.
If the store’s actual expenses are less than 30,000,000, the store is doing well. If the store’s actual costs are more than $30,000, the company must evaluate the store’s profitability.
Examples of profit centers include:
- Restaurant in hotel
- Gift shop at the hospital
- Specialized departments in large retail stores
- Individual product lines in manufacturing companies
Difference between a profit center and a cost center
Cost centers or cost centers and profit centers exist in decentralized companies, which delegate decision-making to lower-level managers rather than relying on top executives to make all company decisions. Both types of centers incur costs to operate, but only profit centers generate revenue.
Profit centers and cost centers work to reduce costs. Cost centers focus on long-term success through a sustainable cost savings approach while profit centers are more concerned with creating strategies for short-term revenue.
A particular profit center may contain several cost centers. For example, consider a large manufacturing company. A company can choose to create a profit center for each product line it produces. Each product line may depend on the following cost centers:
- Maintenance department
- Accounting department
- IT Department
The type of in-depth and specific information produced by the cost center is usually most useful to internal sources than external sources. For example, it is irrelevant for tax authorities to know the salaries of company maintenance staff.
Companies use cost center data for internal tasks, such as:
- Making departmental budget changes
- Evaluating spare parts suppliers
- Create a marketing plan
- Defining processes and protocols
- Improve product quality
Information provided by profit centers helps organizations make broad financial decisions, including:
- Pricing strategy
- Investation decision
- Staff change
- Remove or add products and services