Cost Center vs Profit Center

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

Cost centers and profit centers are both reasons 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 that 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 company's control is from a small team at the top. However, in a decentralized company where the power and the responsibility are shared, you will see cost and profit centers.

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

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

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

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

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

Does the cost center incur costs?

The simple answer is “yes”.

But cost centers incur costs to enable the profit centers to generate profits.

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

So, even if the marketing department incurs costs and doesn't generate direct profits, it enables the sales division to create 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 develops.

Why are cost centers important for organizations?

Many start-ups may argue that there's no need to keep cost centers within the organization since they incur many costs and don't generate direct profits.

The point is that cost centers help profit centers direct the company's functions.

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 develop any new products or innovate on their current products/services.
• There will be no customer service department. That means no customer would be served well if they faced 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 know about the products or the company.

Keeping cost centers is important for long-term health and the organization's perpetuity.

Yes, sometimes they can be outsourced to the right partner if required. 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 shortly.

Types of cost centers

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 assist in processing the products. For example, we can identify an assembly area as a production cost center.
• Service cost centers help provide a support function to enable the other profit center to function well. For example, we can talk about the human resource department as a service cost center since the human resource department helps enable the sales division to make 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 improve.

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

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 being set as per the target to understand how well the mark 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 (favorable).

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 variance would be unfavorable and vice-versa.

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

For example, we can take the sales department. An organization's sales department is a profit center because the sales department ensures how much revenues will be earned, how much expenses the organization should incur to sell the products/services, and how much profits the company would 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” in 1945. After a few years, Peter Drucker corrected himself by saying that there are no profit centers in business, and that was his biggest mistake. He then said that there are only cost centers in a business and no profit center. If 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 create profits.
• Compute returns on investments: Since the profits center also takes charge of revenues and costs, calculating returns on investments becomes 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 don't generate profit should be reduced.
• Help in budgetary control: Since the profit center is evaluated based on deducting actual costs from budgeted costs, profit centers offer more budgetary control. When the actual costs are compared with the budgeted expenses, the profit centers can understand the difference and apply the lessons in the next set of requirements.
• Provides extrinsic motivation: Since the team of the profit center directly controls the outcomes (or revenues and profits), their performance is rewarded, which offers them extrinsic motivation to work harder and 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. For example, the sales division is a profit center of every company. The 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 profit from a huge hotel chain.

How to measure the performance of a particular profit center?

There are five ways to 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 directly measure how accurate we are in our assumption.
• How much profit is generated per unit: As managers of profit centers, it becomes easier to look at the company's profits 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 take the gross profit and divide it by sales, we will get a gross profit percentage.
• Percentage of net profit: If we take the net profit and divide it by sales, we will 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 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 –

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

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

• The cost center takes charge of costs and helps control and reduce the business's costs. On the other hand, the profit center makes sure to generate revenues and profits directly.
• 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; profit centers can be measured 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 influence of profit centers is wide.
• Cost centers ensure the long-term health and profits of a business. Profit centers ensure the short-term profits of a business.
• Cost centers help generate profits indirectly. Profit centers help generate profits directly.

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.

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

This has been a guide to Cost Center vs. Profit Center. Here we discuss the top difference between cost center and profit center, infographics, and a comparison table. You may also have a look at the following articles –

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