The organizations can be divided into different segments based on the function and role performed by each segment. These segments are commonly termed as centers and traditionally categorized into three types – cost centers, profit centers and investment centers. In successful business organizations, all of these centers work together to effectively carry out day to day business activities, engage in competitive environment, increase revenues, improve profits, expand volume and grow market share of their organization.
This article defines and explains the difference between first two types of centers i.e., cost centers and profit centers.
Definitions and meanings
A cost center is a section, unit or department of an organization that incurs costs, consumes resources of the organization and provides services or benefits to other sections or departments of the same organization. These centers only incur costs and do not directly contribute towards revenue and profit of the organization. Their contribution towards revenue and profit is indirect because they do not undertake any revenue generating activities but serve revenue generating departments and other areas of the organizations and play important roles in achieving the organizational objectives.
A basic purpose of establishing cost centers is to utilize the organizational resources in an efficient and effective way so that the maximum benefit can be achieved from the resources utilized and the costs incurred. Normally each individual cost center has its own manager who is responsible for controlling the cost of his cost center and keeping it in line with the allocated budgets. The cost data from each cost center can be easily gathered and compared with the budgeted figures to exercise a better control over cost. A cost center manager is accountable only for the cost incurred in his own cost center and not for any other cost center or area of the business such as investments, prices and revenue related decisions.
Some examples of cost centers that commonly found in many industries are given below:
- Accounting department – handles bookkeeping and accounting needs of the organization
- Human resource management department – is responsible for hiring and firing of company’s employees
- Research and development department – is related to innovation in business and promotion of a learning organization
- IT department – provides IT services
- Quality control department – keeps a check on quality of the goods manufactured by a manufacturing unit
- Legal department – deals litigations against and for the company
- Customer care or customer service center – resolves customers’ product related issues and develops relationship to win the customer loyalty
A profit center is a unit, department, division or branch of an organization that directly contributes towards revenues and profits of the organization by making use of organizational resources. These centers undertake core revenue generating activities of the business like sale of goods and provision of services to customers. The managers in profit centers are usually authorized to take decisions regarding expenditures, resource utilization and revenues maximization etc. They are therefore accountable for activities performed by their profit centers and output generated in terms of revenues, profits and customer relations etc.
Where the profit centers are expected to contribute profits and help flourish the organization’s business, they can actually generate losses and negatively impact the economic condition of the organization as a whole.
The organizations should be able to prepare financial reports for each individual profit center to compute its contribution towards the overall profitability and other organizational objectives. This information helps top management in making critical decisions regarding resource allocation among different profit centers. For example, the organization may want to allocate more resources to highly active and beneficial profit centers and shut down those ones which generate loss and negatively impact the bottom line.
Common examples of profit center are given below:
- The giant IT companies may have separate departments or sections for domain registration, web hosting, web development, custom software development, content writing and search engine optimization etc. Each of these departments can be regarded as a separate profit center.
- The large retailers like Kroger, Amazon and Walmart sell different products through separate departments and each department could be considered a profit center.
Difference between cost center and profit center:
The main points of difference between cost center and profit center are given below:
1. Basic function:
A cost center is a unit or subunit of an organization to which the organization allocates its resources. The activities performed in cost centers only incur cost and do not generate any direct financial inflows for the organization.
A profit center is a unit or area of the business that generates direct financial inflows for the business. Most of the profit centers also incur costs to carry out their revenue and profit generating activities for the business.
The managers of cost centers are responsible for managing costs and are accountable only for the costs incurred by their cost centers. These managers continuously take effective measures to control, reduce or minimize costs without compromising the efficacy of the tasks performed by their cost centers.
The managers of a profit center are responsible for both revenue generation activities and costs incurred to produce those revenues. These managers are mostly liable for their strategies that are formulated to elevate wealth maximization of the organization. They try to enhance revenues and operating profits of their respective profit centers. The area of management in a profit center is wider than that of a cost center because each profit center acts as a small scale business unit which has to produce independent results.
3. Interaction with customers
The profit centers are directly involved in carrying out the processes of delivering goods and providing services to the customers. Therefore they have direct interactions with the customers of the organization. The cost centers, on the other hand, serve areas within the organizations and don’t have such an interaction with the customers.
4. Information needs:
The data and information used by a cost center is mostly generated internally because these centers mostly deal with the internal management and administration of the company. This data can be gathered or demanded from any part of the business. On the other hand, the data used by a profit center can be both internally generated and/or externally gathered because the perspective of decisions made in a profit center are wider than the decisions made in a cost center. Specifically, the management of a profit center has to take into account both the internal bottlenecks of the company and challenges faced by its external competitive environment to make well-gauged decisions.
The scope of a profit center is usually wider than that of a cost center. The tasks performed in a cost center are mainly repetitive and standardized assignments e.g., admin, accounts, HR etc. However, the tasks performed in a profit center are mostly related to budgeting, planning and forecasting activities which are more subjective in nature. These activities are used to devise constructive and practical plans that could be implemented to acquire growth in business revenues and the ultimate income.
Cost center versus profit center – tabular comparison
A tabular comparison of cost center and profit center is given below:
|To manage tasks that only incur costs.||To manage tasks that incur costs as well as generate revenues and profits.|
|The management is accountable for the costs they incur.||The management is answerable for costs incurred as well as revenues and profits generated.|
|Interaction with customers|
|Direct interaction with customers because of direct involvement in the process of provision of goods and services to customers.||No direct interaction with customers.|
|Mostly require internal data only.||Require data from both inside and outside the organization.|
|Scope of economic activities is narrower.||Scope of economic activities is wider.|
Conclusion – cost center vs profit center:
Both profit and cost centers are of vital importance for smooth and effective running of any business organization. Where cost centers are responsible for day-to-day running and administration of a business, profit centers are necessary to generate revenue and profit for the business which is the primary goal of almost every for-profit business entity.
The concept of profit centers is, however, less relevant to non-profit organizations like charities, clubs, hospitals, non-governmental organizations etc. The reason is that a major portion of income of these organizations comes from individual and corporate donations, gifts, subscriptions and government grants etc.
Non-profit organizations make a better use of their cost centers and mostly apply the concepts of three Es (economy, effectiveness, efficiency) to gain an effective control over the costs and resource utilization in their organizational systems.