Cost Center vs Profit Center

Differences Between Cost Center and Profit Center

Cost Center is that department within the organization which is responsible for identifying and maintaining the cost of the organization as low as possible by analyzing the processes and making necessary changes in the company whereas a Profit Center focuses on generating and maximizing revenue streams for the organization by identifying and improving activities such as sales it is much more complex and has a wide area of scope.

Cost centers and profit centers are both reasons for which a business becomes successful. A cost center is a subunit of a company that takes care of the costs of that unit. On the other hand, a profit center is a subunit of a company which is responsible for revenues, profits, and costs.

So a cost center helps a company identify the costs and reduce them as much as possible. And a profit center acts as a sub-division of a business because it controls the most important key-factors of every business.

You won’t see a cost center and a profit center in a centralized company; since the control of the company is from a small team at the top. In a decentralized company where the control and the responsibility are shared, you will be able to see the existence of cost and profit centers.

Cost-Center-vs-Profit-Center

In this article, we discuss cost center vs profit center in detail –

Cost center vs Profit center [Infographics]

There are many differences between cost center vs profit center. Here are the top differences –

Cost-Centre-vs-Profit-Centre

 

Now that we understand the basic differences between Cost Center vs Profit Center, let us look at each one of them in detail.

What is Cost center?

A cost center is a subunit (or a department) that takes care of the costs of the company. The primary functions of the cost center are to control the costs of the company and to reduce the unwanted costs the company may incur.

For example, the customer service facilities may not create direct profits for the company, but it helps control the costs of the company (by understanding what customers are struggling with) and also facilitates in reducing the costs of the organization.

Does cost center incur costs?

The simple answer is “yes”.

But cost centers incur costs so that it can enable the profit centers to generate profits.

For example, we will call the marketing department as a cost center because the company invests heavily in marketing. Because marketing function enables the sales division to generate profits.

So, even if the marketing department is incurring costs and doesn’t generate direct profits, it enables the sales division to generate direct profits for the company.

The marketing department also helps understand what the customer needs, as a result, the organization stops doing what doesn’t generate profits and starts doing more of what brings in the result.

Why are cost centers important for organizations?

Many start-ups may argue that there’s no need to keeping cost centers within the organization since they incur a lot of costs and also don’t generate direct profits.

The point is cost centers help profits centers in directing the functions of the company.

Let’s say there’s no cost center in the organization. That means –

  • There will be no research & development in the organization. As a result, the organization won’t be developing any new products or won’t innovate on their current products/services.
  • There will be no customer service department. That means no customer would be served well if they face any challenge or issue.
  • There will be no branding or marketing department which means that the company will keep producing products but no-one will get to know about the products or about the company.

Keeping cost centers are important for the long term health and for the perpetuity of the organization.

Yes, if required, sometimes they can be outsourced to the right partner. But without the assistance of the cost centers, the profit centers won’t function well. And as a result, there will be less/no profit generation in near future.

Types of cost centers

Basically, there are two types of cost centers.

  • Production cost centers: These cost centers help in production processes. The usefulness of these sorts of cost centers lies in how seamlessly they can help in processing the products. For example, we can identify an assembly area as production cost center.
  • Service cost centers: These cost centers help provide a support function to enable the other profit center to function well. For example, we can talk about human resource department as service cost center since human resource department helps to enable sales division into making more profits for the business.

How to measure the performance of a particular cost center?

It’s said that if you can’t measure something, you won’t be able to improve.

That’s why we need to find a way to measure the performance of a cost center.

Simply put, to measure the performance of a cost center, we need to do a variance analysis through which we would be able to see the difference between the standard cost and the actual cost.

Standard costs are costs which are being set as per the target and to understand how well the target is being fulfilled.

Actual costs are the costs that are incurred in reality.

Variance analysis can be done in two ways – first through price variance and then through quantity variance.

Let’s take an example to illustrate this.

Cost Center Example

  • The actual price of the material = $5 per unit.
  • The standard price of the material = $7 per unit.
  • Actual units of materials = 10,000.
  • Standard units of materials = 9700.

Find the price & quantity variance.

We have been given all the information.

The formula of price variance is = Actual units of materials * (Actual price per unit – Standard price per unit).

In this example putting all the figures in the formula, we get –

Price variance = 10,000 * ($5 – $7) = $50,000 – $70,000 = $20,000 (favourable).

When the actual price is less than the standard price, the price variance would be favorable and vice-versa.

To find out quantity variance, we need to look at the formula of quantity variance.

Quantity variance = (Actual quantity – Standard Quantity) * Standard Price

Putting the figures into the formula, we get –

Quantity variance = (10,000 – 9700) * $7 = 300 * $7 = $2100 (Unfavourable).

When the actual quantity is more than the standard quantity, the quantity variance would be unfavorable and vice-versa.

What is Profit center?

A profit center is a center which generates revenues, profits, and costs.

For example, we can take sales department. Sales department of an organization is a profit center because sales department ensures how much revenues will be earned, how much expenses should organization incur to sell the products/services, and how much profits would the company make as a result.

Profit centers are the reasons for which business is run. Without profit centers, it would be impossible for a business to perpetuate.

Of course, profit centers are backed up by cost centers to generate profits, but the functions of profit centers are also noteworthy.

Management guru, Peter Drucker first coined the term “profit center” back in 1945. After few years, Peter Drucker corrected himself by saying that there are no profit centers in business and that was his biggest mistake. He then concluded by saying that there are only cost centers in a business and no profit center. If there is any profit center existed for a business; that would be a customer’s check that hadn’t been bounced.

Functions of profit center

Profit centers have few specific functions. They’re as follows –

  • Generate profits directly: Profit centers help generate direct profits from their activities. For example, the sales department directly sells products to customers to generate profits.
  • Compute returns on investments: Since profits center also take charge of revenues and costs, calculating returns on investments become easy in profit centers.
  • Help in effective decision making: Since the activities of profit centers are directly generating revenues and profits, it’s easier to make effective decisions. The activities that generate the most revenues & profits should be done more and activities that increase the cost but doesn’t generate profit should be reduced.
  • Help in budgetary control: Since the profit center is evaluated on the basis of deducting actual costs from budgeted costs, profit centers offer more budgetary control. When the actual costs are compared with the budgeted costs, the profit centers are able to understand the difference and can apply the lessons in the next set of requirements.
  • Provides extrinsic motivation: Since the team of the profit center directly control the outcomes (or revenues and profits), their performance is directly rewarded which offers them extrinsic motivation to work harder and to generate more profits.

Also, check out this article on Budgeting vs Forecasting | Is it Same or Different?

Types of profits center

Profit centers can be of two types.

  • A department within the organization: Profit centers can be departments within the organizations. For example, sales division is a profit center of every company. Sales division is a department and at the same time, it is within the organization.
  • A strategic unit of a big organization: Profit centers can also be sub-units or strategic units of a big organization. For example, a restaurant can be a profit center of a huge hotel chain.

How to measure the performance of a particular profit center?

There are actually five ways through which we can measure the performance of the profit center. Let’s have a look at all of them –

  • Comparison between budget and profit: Every profit center creates a budget for the cost and revenue. When we compare with the actual cost and actual revenue, we get a direct measure of how much we are accurate in our assumption.
  • How much profit is generated per unit: As managers of profit centers, it becomes easier to look at the profits of the company and then divide it by the number of units sold. As a result, we can get the profit per unit.
  • Percentage of gross profit: If we simply take the gross profit and divide it by sales, we will be able to get a gross profit percentage.
  • Percentage of net profit: If we simply take the net profit and divide it by sales, we will be able to get a net profit percentage.
  • Ratio between expenses and sales: Since a profit center can see the actual expense and the actual sales, it’s easy to find out a ratio between them.

Profit Center Example

Let’s take an example to use the three measures of profit center and how the company is doing –

Particulars Amount (in $)
Revenue 100,000
Cost of Goods Sold 70,000
Gross Margin 30,000
Labour 5000
General & Administrative Expenses 6000
Operating Income (EBIT) 19,000
Interest Expenses 3000
Profit Before Tax 16,000
Tax Rate (25% of Profit before tax) 4000
Net Income 12,000

If we use the above data to find out the measurement, here’s the computation –

  • Gross profit percentage = Gross Profit / Sales * 100 = 30,000 / 100,000 * 100 = 30%.
  • Net profit percentage = Net Profit / Sales * 100 = 12,000 / 100,000 * 100 = 12%.
  • Expense/Sales = 18,000 / 100,000 * 100 = 18%

(Note: Expense here includes labor, general & administrative expenses, interest expenses, and tax expense)

Also, check out this article on Profit Margins

Cost Center vs Profit Center – Key differences

Here are the key differences between cost center vs profit center –

  • Cost center takes charge of costs and helps in controlling and reducing costs of the business. Profit center, on the other hand, makes sure to directly generate revenues and profits.
  • According to Management Guru, Peter Drucker cost centers are the only requirement of a business. But other management thinkers think that even profit centers are essential ingredients of a good business.
  • It is important to measure the performance of cost centers; we do that by using variance analysis. The performance of profit centers should also be measured; the measurement of profit centers can be done through gross profit percentage, net profit percentage, expense/sales percentage, profit per unit etc.
  • The area of influence of cost centers is narrow. But on the other hand, the area of influence of profit centers is wide.
  • Cost centers ensure the long term health and profits of a business. Profit centers ensure short term profits of a business.
  • Cost centers help generate profits indirectly. Profit centers help generate profits directly.

Cost center vs Profit center (Comparison Table)

Basis for Comparison – Cost Center vs Profit Center Cost center Profit center
1.    Meaning Cost center is a subunit/department of a company which takes care of the costs. Profit center is a subunit of a business which is responsible for profits.
2.    Responsible for Cost control and cost reduction. Maximizing revenues and profits.
3.    Area of influence Narrow. Wide.
4.    Type of work Simple since it only focuses on costs. Complex since it focuses on revenues, profits, and costs.
5.    Generation of profits Doesn’t directly generate/maximize profits. Directly generate and maximize profits.
6.    Approach – Cost Center vs Profit Center Long term. Short term & long term both.
7.    The health of business Cost centers is directly responsible to ensure good health of the business in the long run. Profit centers are backed by cost center to ensure the perpetuity of business.
8.    Computation Standard Costs – Actual Costs Budgeted Costs – Actual Costs
9.    Used  for – Cost Center vs Profit Center Internal (mainly) Internal & external (both)
10.  Example Customer Service Facility Sales division

 Conclusion

Cost centers vs profit centers, both are important for the business. If any organization thinks that the cost centers are not required to generate profits, they should think twice. Because without the support of cost centers, it would be impossible to run a business for a long period of time.

Rather it can be said that without profit centers, cost centers still would be able to generate profit (though not so much); but without the backing of cost centers, profit centers won’t exist at all.

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