Dividing business operations of the whole organization into Cost Centers and Profit Centers is important to any large business. It is when a small business grows, it becomes more and more difficult to manage it, especially its finance.
Cost Centers help managers to identify which costs are attributed to which product, unit, section, department or branch of the firm. They also show how each Cost Center contributes towards the firm’s overall Total Costs (TC), and which Cost Center generates the highest costs.
Profit Centers help to determine which Profit Center generates the most, or the least profit, and how each Profit Center contributes towards the overall profits of the business.
Advantages of Cost Centers and Profit Centers
- Help with cost allocations. All costs, both Fixed Costs (FC), Variable Costs (VC) and Semi-Variable Costs (SVC) are allocated across the various Cost Centers regardless of their type. So, managers do not need to waste their precious time trying to figure out what types of costs they are dealing with.
- Motivate. When workers and managers have the clear aim, objectives and targets to work towards, this will have positive impact on employee motivation. Because the performance of each Cost Center and Profit Center can be measured using hard quantitative data, after achieving their goals, employees will be rewarded accordingly. The rewards will encourage people to work even harder.
- Create accountability. It was mentioned earlier that managers will be responsible for their department’s performance – either contribution towards the firm’s cost reduction or the overall profit increase. Accountability for results will improve as well as productivity within the different areas of the business and teamwork. The best performing managers will be appropriately recognized for their hard work.
- Aid decision-making. Thanks to Cost Centers and Profit Centers, managers can identify loss-making products, units, sections, departments or branches of the business. They will monitor if a certain part of the business is making a loss, and if so, decisions will be made about the future – whether to stop or not to stop making a product.
- Enable to measure performance. Cost Centers and Profit Centers enable the business to make comparisons between current performance and past performance, as well as to help identify those areas performing badly. Benchmarking can be used to identify the best Profit Centers within the business, and then make improvements in other Profit Centers to make them as good as the best one.
Disadvantages of Cost Centers and Profit Centers
- Cost and profit allocations are not always straightforward. Some costs may be very difficult to allocate objectively to a particular Cost Center or Profit Center. It is because the accurate allocation of certain Indirect Costs (Overheads) such as security fee or insurance fee into specific products, units, sections, departments or branches of the business might be impossible. And when managers are not being able to correctly calculate the overheads attributable to each Cost Center or Profit Center due to the problems with apportionment of Indirect Costs (Overheads), then the profit cannot be properly calculated.
- External factors may contribute to good performance. Good or bad business performance of a particular Profit Center can be caused by random external factors. These external influences that are beyond the business’s control such as higher packaging or transportation costs will reflect on a short-term performance, but will be misleading when it comes to the real long-term productivity and efficiency of the individual department.
- Conflicts between employees. Workers and managers may consider the part of the business that they work for to be much more important than the long-term success of the whole business organization. Conflicts may arise between Cost Centers as to which one gets allocated more resources. Also, there might be a fierce competition between Profit Centers as to which one gets new customers. Another area of conflict may involve unhealthy attempts to cut costs dramatically in order to look better on paper than other Cost Centers. This may negatively impact product quality and customer satisfaction leading to loss of revenue and customer loyalty in the long-term perspective.
- Costs data collection is demotivational. Costs data collection is required to accurately calculate all costs and profit. However, in very large multinational companies, this process will be very time consuming, hence expensive. While collecting financial information can be very tedious for workers, managers may face increased pressure and stress. This can lead to unhappiness of staff and increases in employee turnover.
- Lower Corporate Social Responsibility (CSR). Different employees responsible for Cost Centers and Profit Centers for different products, units, sections, departments or branches may compete, or fight, with one another. While some sales personnel may use misleading sales techniques to increase sales revenue, some managers may ‘cook the books’ to make their respective Profit and Loss Accounts (P&L) look better than the actual situation. These kinds of unethical actions may lower the overall Corporate Social Responsibility (CSR) of the whole business negatively impacting the reputation of the firm.
In short, by dividing a business organization into these Cost Centers and Profit Centers, certain benefits are likely to be gained. However, as we can see above, there are also some problems with using these centres by management.
