Cost Center

Cost center refers to departments that do not contribute to generating revenue or profits for the company. Still, 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.

These areas are mainly associated with any kind of support function. These activities do not generate revenue directly but they are very important for the overall smooth running and functioning of a company. However, they contribute to budgeting and cost control, helping the business take informed financial decision.

A cost center is that unit in an entity that incurs cost but does not directly contribute to the revenue earning process. But they play a very important role in running the enterprize smoothly and efficiently.

The expenses can be related to salary, utility, wages, rent, maintainance, essential supplies, etc. The cost allocated through the cost center code of all these units are proportionately divided or distributed among responsible departments through which the company can track and manage them, The analysis done is useful in cost control upgrading efficiency level.

The variances of the deviation from the cost can be analysed to identify inefficiency based on which reports are made for monitoring and evaluation of finamcial performance. Through this method proper and effective measures are take n for controlling the level of expenses and channalize them wherever there is a higher requirement.  The cost center can vary as per the industry or the type of business and company structure.

Given below are some important types of cost center that commonly exist in the business environment.

The expense center can be classified into the following six types having their own cost center code, based on the nature of business activities:

#1 - Personal

This type of expense center deals with a person or group of persons.

#2 - Impersonal

This type of center deals with a location or equipment or both.

#3 - Production

This type of expense center deals with a product or manufacturing work. A few examples of production centers are welding shops, machine shops, grinding shops, painting shops, polishing shops, assembly shops, etc.

#4 - Service

Suppose a cost pool deals with or is associated with rendering services to a production center. A few examples of this cost center type 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 center -  Example include stores, internal transport, etc.
• The personal service center - Example includes the labor office, canteen, etc.
• Plant maintenance center - Examples include tool room, carpentry, smithy, etc.

#5 - Operation 

Suppose an expense center consists of machines or persons involved in similar activities. This type of cost pool is relevant to manufacturing concerns.

#6 - Process 

Suppose a cost pool deals with a specific process of a manufacturing enterprise. This type of center is also relevant to manufacturing concerns.

Let us understand the concept with the help of an example.

For instance, let us take the example of a company’s accounting and legal department. Although both the departments consume appropriate 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 unnecessary because they can save the company money in the long-term through other allied activities, i.e. the accounting department supports the preparation of financial statements and tax reporting as per their cost center number, while the legal department shall take care of any legal disputes.

Cost Center Accounting is a departmental division, self-division, or a group of machines or men used for cost assignment and allocation. It includes various units of activity required in a manufacturing plant or similar operating setup.

• It 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 a cost pool or expense center.
• 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 the preparation of the budget (annual or monthly) for each cost pool. After that, all the company transactions are classified by cost pool, and a periodic cost center 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 determine the variance between the budgeted and the actual amounts. Consequently, responsibility accounting provides the company with periodic feedback on each cost center manager performance.

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. Cost control becomes much easier if the responsibility is assigned to a cost center manager. As such, cost centers are also known as "Responsibility centers." cost control becomes much easier. As such, cost centers are also known as “Responsibility Center.”, having their own cost center number.

A cost pool indirectly supports a company's profitability by improving operational efficiency, resulting in better customer service or increased product value. An expense center can also help the senior management understand resource utilization better, eventually assisting 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 cost center report, the 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.

Given below are the terms related to the cost pool.

#1 - Profit Center

A profit center is an organizational division accountable for its profitability on a standalone basis. A profit center is responsible for controlling its own cost, generating revenue, and consequently for its net earnings. Hence, 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.

#2 - 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.

The above are two types of units in an organization but the purpose of their operation are completely different. Let us compare the two and pint out their differences.

• The former is a unit within the organization that incurs cost but does not contribute to the profits directly. But the latter is a department or a business unit that is directly responsible for generation of revenue or profit.

• The former mainly focuses on cost control and efficiency enhancement while the latter mainly focuses on enhancement of financial performance through betterment or upgradation of goods and services.
• The former typically deals with support functions like human resource department, information technology department, maintainence and administration units, etc.  The latter are mainly sales, product lines, etc.
• The autonomy and authority to take decision independently is more in case of profit centers than cost centers.  

• The profit centers have their own profit and loss statements whereas the cost centers do not have them.

• The former supports the organization through management and cost control whereas the latter supports the organization through revenue generation.

Both play a very important role in a company and their performance evaluation based on organizational objective is extremely important.

This has been a guide to Cost Center and its meaning. We explain it with examples, differences with profit centers, accounting, types, relevance & uses. You may learn more about our articles below on accounting –

• List of Operating Expenses
• Relevance in Accounting
• Prudence Concept in Accounting
• Single Entry System in Accounting