Cost centre and profit centre are integral to business success, even though those function differently with a different set of objectives.
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What is the Cost Centre?
A cost centre is a department or sub-unit in an organisation that focuses on costs incurred by it. Its function involves controlling and reducing high costs that may be incurred by a company.
For instance, a customer service centre would not directly generate revenue or profit for an organisation but helps in controlling costs which may arise from unmitigated customer complaints and grievances.
It must be noted in this regard, that the cost centre itself incurs a cost, but it enables a profit centre to generate more revenue and profit.
It may be measured by comparing standard costs against targeted costs. It will help to understand how, or to what extent targets are met.
There exists a difference between cost centre and cost unit. Cost unit is necessarily measured in terms of service or product unit. On the contrary, the cost centre is a division within a company.
Importance of Cost Centre
Cost centres, even though they do not directly generate revenue, play a critical role in business success. In the absence of cost centres, there will be no research and development, marketing department, or customer service department. Without R&D, a company will not be able to innovate on its service or product.
Lack of marketing department will impede customer awareness, adversely affecting its sales.
Types of Cost Centre
1. Service Cost Centres
Service cost centres extend support to profit centres so that the latter can function efficiently. The Human Resources department is an example of service cost centres. The HR department is intricately connected to the sales department.
2. Production Cost Centres
These centres directly enable the processes of production. For instance, an assembly line is held as a product cost centre. It ensures seamless production.
What is the Profit Centre?
A profit centre is that department in a company that engages in the generation of profit and revenue, and also takes into account the costs associated with it.
For instance, a sales department is directly related to profit generation of a company. It also determines revenue projections.
Profit centre does not operate in silos but backed by cost centres.
There are multiple ways of measuring the performance of a profit centre. One of the most popular methods is to compare between profit and budget.
Importance of Profit Centre
A profit centre is crucial for an organisation or a company because its primary function is to generate profit. It also helps in the computation of investment returns.
As measures adopted by profit centres lead to profits and revenue, it also helps in efficient decision-making. Activities that are most likely to increase costs are done away with. A profit centre also has a role to play in budgetary control.
Types of Profit Centre
1. Intra-Organisational Department
Departments of such profit centres are located within a company. For instance, a sales division as a department exists within a company. It is the most important profit centre in any organisation.
2. Strategic Unit of a Larger Organisation
For a multi-national corporation or larger corporates, there are strategic sub-units located outside the entity. For instance, in the case of a large hotel chain, a restaurant will act as a strategic unit profit centre.
Cost Centre vs Profit Centre
The difference between cost centre and profit centre is discussed below.
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FAQs on Cost Centres vs. Profit Centres
1. What is a cost centre in the context of business management?
A cost centre is a specific department or function within an organisation that incurs costs but does not directly generate revenue or profit. The primary purpose of a cost centre is to perform its duties while keeping expenses under control and within the allocated budget. Its manager is held accountable only for the costs it incurs. For example, the Human Resources (HR) or Accounting departments are classic examples of cost centres.
2. What defines a profit centre within an organisation?
A profit centre is a division or branch of a company that is treated as a separate business unit responsible for both its revenues and its costs. The manager of a profit centre is accountable for its profitability. This structure allows management to assess the performance of individual units and make strategic decisions about resource allocation. A specific retail store in a chain or a particular product line are common examples.
3. What are the key differences between a cost centre and a profit centre?
The main differences between a cost centre and a profit centre are based on their objectives and responsibilities:
- Objective: The primary objective of a cost centre is to minimise costs and operate efficiently within a budget. A profit centre aims to maximise profit by managing both revenues and expenses.
- Responsibility: A cost centre manager is only responsible for costs. A profit centre manager is responsible for both revenues and costs, and ultimately, the unit's bottom-line profit.
- Scope: Cost centres typically have a narrower, more functional scope (e.g., IT support), while profit centres have a broader, more business-oriented scope (e.g., a product division).
- Decision-Making: Decisions in a cost centre are related to operational efficiency, whereas decisions in a profit centre also include pricing, marketing, and sales strategies.
4. What are some common examples of a cost centre in a manufacturing company?
In a typical manufacturing company, several departments function as cost centres because they provide essential support without directly selling products. Common examples include:
- The Human Resources (HR) department, which manages employee relations and payroll.
- The Information Technology (IT) department, responsible for maintaining computer systems.
- The Accounting and Finance department, which handles bookkeeping and financial reporting.
- The Maintenance Department, responsible for servicing machinery and facilities.
- The Customer Service call centre, which handles queries and complaints.
5. Can you provide examples of a profit centre in a large retail business?
Yes, in a large retail business, profit centres are used to evaluate the performance of different segments. Typical examples are:
- Each individual store or branch in a retail chain.
- Specific departments within a large department store, such as the 'Electronics Department' or the 'Home Goods Department'.
- A specific product line, for instance, the company's own 'private label' brand of products.
- The e-commerce website, which operates as a distinct sales channel with its own revenues and costs.
6. How is the performance of a cost centre evaluated differently from a profit centre?
The performance evaluation methods are fundamentally different. A cost centre's performance is measured mainly through variance analysis, where its actual costs are compared to the budgeted or standard costs for a period. The focus is on efficiency and cost control. In contrast, a profit centre's performance is measured by its profitability. Key metrics include the net profit, gross margin, and contribution margin, which are compared against targets or previous periods.
7. What is the strategic importance of using both cost and profit centres in a company?
Using both types of centres is a key strategy for decentralised management and enhanced accountability. Cost centres ensure that essential support functions are performed efficiently and economically without the distraction of revenue generation. Profit centres foster an entrepreneurial spirit within business units, empowering managers to make decisions that drive growth and profitability. This dual structure helps senior management to accurately assess which parts of the business are creating value and which are consuming resources, leading to better strategic planning.
8. Can a department that generates some revenue still be classified as a cost centre?
Yes, this is a common point of confusion. A department can generate incidental revenue but still be classified as a cost centre if its primary purpose is not profit generation. The key factor is how its performance is measured. For example, a university's printing department might charge other departments for its services (generating revenue), but its main goal is to provide low-cost printing support to the university, not to maximise profit. Therefore, it would be managed and evaluated as a cost centre based on its operational efficiency.
9. How do investment centres and revenue centres relate to cost and profit centres?
These are all types of responsibility centres, but with different levels of accountability:
- Revenue Centre: Responsible only for generating sales revenue (e.g., a sales department).
- Cost Centre: Responsible only for controlling costs.
- Profit Centre: Responsible for both revenues and costs.
- Investment Centre: This is the highest level of responsibility. A manager of an investment centre is accountable for revenues, costs, and the capital invested in their unit's assets. Their performance is often judged by metrics like Return on Investment (ROI), which links profit directly to the assets used to generate it.
