Cost centres and profit centres
Previously, we met the concept of budgets and variance analysis. These are part of the management accounting function within a company. Financial plans are used to predict what will happen, and become the basis for action where necessary. They are rather like the data used when navigating a ship or aircraft. They measure and report where a company is, and enable the management to plot a course, so that it arrives at its financial destination.
If a firm is to maximise profit it needs effective financial management. Forecasting and controlling revenues and expenditure is the basis for this financial planning. The difference between the total revenues and total cost is the profit. If the firm is large the management of revenues and costs is likely to be complex, so the firm is often divided up into a series of departments, or cost and profit centres to simplify the process and to support more micro-analysis. Cost and profit centres can be isolated financially with individual managers held responsible for costs incurred, and revenues generated.
The concepts of profit and cost centres underpin effective financial management.
A profit centre is a division, or part of an organisation, where costs and revenues can be clearly identified, isolated and recorded allowing the profit it generates to be determined. The profit centre should be under the control, or responsibility, of one manager.
A cost centre is a division or part of an organisation that generates costs which can be clearly identified, isolated and recorded, but is not directly producing revenues so profit cannot be determined. The cost centre should be under the control, or responsibility, of one manager.
Examples of profit/cost centres:
- groups of machines
- locations e.g. regional offices
For example a school may be both a profit and a cost centre. If a school is privately run and part of a consortium or group of schools, and students (or their parents) are charged fees, the school generates revenues and costs. The profit can be calculated for each school in the consortium and performance measured. However, identifying profit centres within schools is more problematic. Can a department be a profit centre? This would be difficult unless a notional fee is established for a particular course or subject to calculate total revenues. It is more likely that departments within schools, both in the profit and non-profit sectors, will be considered cost centres. Costs can be identified in terms of teacher wages and the costs of equipment and materials used in that department. Most departments are allocated a budget which provides responsibility and accountability.
One advantage of cost centres is that the firm is not concerned if costs are fixed or variable. If it is a cost, then it belongs in a cost centre.
The purpose of creating cost and profit centres is to develop a financial system where there is direct responsibility and accountability. For this to be an effective system, there must also be authority. In other words, the person managing a cost or profit centre must also have the authority to change things and make decisions, as well as carrying the responsibility when things go wrong.
NO ACCOUNTABILITY WITHOUT AUTHORITY
All divisions of an organisation are potentially cost centres. Examples are production, personnel, accounts, and transport. A few, however, are profit centres as well. Examples are the sales department or, if the firm is organised that way, individual brands.