All businesses operate through different units or departments. Departments are generally classified on the basis of their functions and their contribution to the business. Identification of departments is essential for multiple reasons including cost allocation and budgeting, staff management, profitability and efficiency analysis etc.
This article looks at meaning of and differences between two different types of units of any business – cost center and profit center.
Definitions and explanations
A cost center is a unit of a business that is responsible for incurring of costs. A cost center is generally that part of a business that does not directly generate revenue but supports the functioning of key revenue generating departments of a business. It thus incurs costs during its operation. A cost center is termed as such as costs are incurred by it to keep it running.
Example – in any operating concern, there are several support functions that are necessary to keep the business running – such as administration department, accounts and finance departments, human resources departments etc. These are examples of costs centers for a business.
Management often allocates costs on the basis of cost centers. This aids cost budgeting and cost control. The focus of management of a business is generally to limit costs of a cost center without impacting it functions.
A profit center is a unit of a business that is responsible for generating revenue for the business. A profit center utilizes business resources to generate revenue and thus has both identifiable revenues and identifiable costs.
Allocation of revenues and costs to profit centers is essential as it helps to identify relative profitability of different revenue generating divisions. This helps management in taking various decisions related to income generating operations of the business.
Example – in a manufacturing concern, the production and sales department of different product lines are profit centers. In a retail store, different product categories may be different profit centers. In an IT concern, profit centers may be categorised on various parameters such as sale of products and sale of services, local and export sales etc.
The focus of management with regards to profit centers, is to maximise revenues generated and limit costs incurred to optimise overall profitability of the department.
Difference between cost center and profit center:
The main difference between cost center and profit center have been detailed below:
- A cost center is a department or sub-division of a business that is responsible for cost incurrence.
- A profit center is a department or sub-division of a business that is responsible for revenue generation for a business.
2. Contribution to revenue
- A cost center does not directly generate revenue or profit for the business. It in fact supports the operation of profit centers.
- A profit center directly generates revenue for the business through its operations.
- Cost centers are generally segregated into several departments or sub-divisions on the basis of functions or activities performed such as administration, accounts and finance, employee relations, customer relations etc.
- Profit centers are generally segregated on sales related parameters such as varied product lines, area of sales etc.
- The primary purpose of cost centers is to support revenue generating functions of the business through its operations. For e.g. – human resources department supports the business by managing matters of employees who work directly to generate revenue.
- The primary purpose of profit centers is to generate actual revenue for the business. For e.g. –different product lines in a manufacturing concern.
5. Management focus
- The focus of management with regards to cost centers is to minimize costs without hampering functions of the departments.
- The focus of management with regards to profit centers is to maximize revenue generation while limiting costs to maximize overall profits.
6. Authority of department heads
- Department heads of cost centers have limited decision making authority – limited to controlling costs within pre-determined standards.
- Department heads of profit centers generally have wider decision making authority – such as determination of production levels, product pricing etc.
7. Performance analysis
- The performance evaluation of cost centers is done by comparing and analyzing actual costs in comparison to standard costs pre-determined for different departmental functions.
- The performance evaluation of profit centers is done by comparing actual costs incurred to budgeted costs determined for specific revenue levels.
8. Analysis of activities
- Analysis of cost center activities is simpler as it only deals with costs.
- Analysis of profit center activities is more complex as they deal with both revenues and costs.
- Cost centers are relevant as they accumulate information on costs which is used for cost budgeting, cost control and for various internal MIS reports. They are thus an essential part of management accounting.
- Profit centers are relevant as they accumulate information on profitability which is used for various production, pricing and sales related decisions.
- Cost centers include administration department, accounts and finance, human resources, information technology department, customer relations etc.
- Profit centers include different product lines in a manufacturing concern, different sales departments in a retail store, IT hardware sale and IT software services in an information technology company etc.
Both cost centers and profit centers are essential to the functioning of a business. The efficient operation of a business is a result of the combined working of several departments of a business. Thus neither cost centers nor profit centers can be viewed or analysed in isolation. So for example while boosting production and sales of products and services is essential in a business, the relevance of support functions cannot be undermined as they too contribute to the effective running of the business.