- Budgeting in Finance
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- Fixed Budget vs Flexible Budget
- Zero Based Budgeting
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- Cost Center
- High-Low Method Formula
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Cost center refers to those departments of the company which does not contribute in the generation of the revenue or profits to the company but at the same time costs are incurred by the company to operate those departments and include departments such as the Human resource department, accounting department, etc.
What is Cost Center Accounting?
Cost Center Accounting is a departmental division, self-division or a group of machines or men used for the purpose of cost assignment and allocation and includes various units of activity required in a manufacturing plant or other similar operating set-up.
- It is to be noted that a cost center is a unit that generates cost but does not generate any revenue. In short, it can be seen as a unit that consumes resources but does not contribute to the production, sales or profitability of the business per se.
- A cost center is also known as cost pool or expense center.
- For instance, let us take the example of the accounting department and the legal department of a company. Although, both the departments consume reasonable resources of the company, neither of these departments directly help in product manufacturing or increase sales in any way. This does not mean that these departments are not necessary because they can save the company money in the long-term through other allied activities i.e. the accounting department supports preparation of financial statements and tax reporting, while the legal department shall take care of any legal disputes.
Relevance and Uses of Cost Center
The primary purpose of a cost pool is to create a distinctly identifiable department, division or unit of an organization for which concerned managers will be responsible for all its associated costs and for ensuring adherence to the organization’s budgets. If the responsibility is assigned to a manager, the cost control becomes much easier. As such, cost centers are also known as “Responsibility Center”.
A cost pool indirectly supports a company’s profitability by improving operational efficiency which results in better customer service or increase in product value. An expense center can also help the senior management to understand resource utilization better which will eventually assist them in utilizing the resources optimally through smarter techniques. Further, accounting for resources in such detail allows a company to forecast and calculate more accurately based on expected future changes.
For internal reporting, cost pool provides relevant information to improve operational efficiency and maximize profit. On the other hand, it is of very little use for external users such as taxation authorities, regulators, creditors, investors etc.
Types & Examples of Cost Center Accounting
The expense center can be classified into the following six types based on the nature of business activities:
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#1 – Personal Cost Center:
This type of expense center deals with a person or group of persons.
#2 – Impersonal Cost Center:
This type of center deals with a location or equipment or both.
#3 – Production Cost Center:
This type of expense center deals with a product or manufacturing work. Few examples of production center are welding shop, machine shop, grinding shop, painting shop, polishing shop, assembly shop etc.
#4 – Service Cost Center:
If a cost pool deals with or is associated with rendering services to a production cost center, then it is known as Service Cost Center. Few examples of this type of cost center are transport, stores, accounts, power, personnel department etc.
The service center is further sub-divided into three categories which are as below:
- The material service cost center – Example include stores, internal transport etc.
- The personal service cost center – Example includes labor office, canteen etc.
- Plant maintenance cost center – Examples include tool room, carpentry, smithy etc.
#5 – Operation Cost Center
If an expense center consists of machines or persons which are involved in similar activities, then it is known as Operation Cost Center. This type of cost pool is relevant to the manufacturing concerns.
#6 – Process Cost Center
If a cost pool deals with a particular or specific process of a manufacturing enterprise, then it is known as Process Cost Center. This type of center is also relevant to manufacturing concerns.
Other Important terms related to Cost Center
Given below are the terms related to the cost pool.
#1 – Responsibility Accounting
The concept of responsibility accounting revolves around a company’s internal accounting and budgeting. The main objective of the accounting type is to help a company in planning and control its expense centers which are also known as responsibility centers.
Usually, responsibility accounting entails preparation of the budget (annual or monthly) for each cost pool. After that, all the transactions of the company are classified by cost pool and a periodic report is created which is the input for further cost analysis. The reports capture the actual expense vis-à-vis the budgeted expense which helps in the determination of the variance between the budgeted and the actual amounts. Consequently, responsibility accounting provides to the company the periodic feedback of each manager’s performance.
#2 – Profit Center
A profit center is an organizational division which is accountable for its own profitability on a standalone basis. A profit center is responsible for controlling its own cost and generating revenue and consequently for its own net earnings. Consequently, managers have the authority to make decisions for matters related to product pricing and operating expenses. All the different profit centers within an organization can be ranked from being the most profitable to be the least profitable.
#3 – Investment Center
An investment center is an organizational division that contributes to a company’s profitability by efficiently utilizing the capital. A company usually evaluates the performance of its investment center based on the revenue generated through capital investment. An investment center is also responsible for its own revenues, expenses, and assets. An investment center is also known as an investment division.
This has been a guide to what is Cost Center Accounting. Here we discuss the top 6 types of cost centers along with practical examples and its relevance and uses. You may learn more about our articles below on accounting –