What it means
A business spends money in many places, and the first step in controlling it is to assign every cost to someone who can influence it. Cost centres do that: they divide the organisation into units small enough that a manager can be responsible for what is spent there, and they collect the costs so that the manager and the business can see them.
A factory may have cost centres for each production line, maintenance, quality, stores and the plant office; a head office for finance, HR, IT, legal, marketing and facilities; a hospital for each ward, theatre, department and support service. The manager of a cost centre controls inputs (staff, materials, services, equipment) and is accountable for spending within budget and for the efficiency with which the centre delivers its output.
The manager is not accountable for revenue, because the centre does not sell anything; a production department transfers its output to the next stage or to finished goods, and a support department provides services to other departments. Performance is measured by cost against budget (with variances explained), by cost per unit of output (cost per unit produced, per invoice processed, per ticket resolved, per employee served), by service levels, and by comparison with benchmarks or with outsourcing alternatives.
Cost centres feed cost accounting. Their costs are allocated to the cost objects that consume them: production cost centres to the products they make, service cost centres to the production centres or business units they serve, and then onward to products.
The allocation bases (headcount for HR, square footage for facilities, users or tickets for IT, machine hours for maintenance) determine where the costs land, and a poor base misallocates costs and misstates the profitability of what receives them. Some businesses charge support costs to users through internal service level agreements and transfer prices, converting the cost centre into a quasi-profit centre so that users see the cost of what they consume and the provider has an incentive to be efficient.
The limitations are well known. A cost centre manager judged only on cost has an incentive to cut cost at the expense of service or quality that the centre's users bear; an IT department that meets its budget by delaying upgrades, or a maintenance department that defers work, has hit its target and harmed the business.
Cost centre budgets tend to be incremental and to be spent in full to protect next year's allocation. And cost centres can be defined too coarsely (one centre for a whole plant, with no visibility of where costs arise) or too finely (hundreds of centres, with allocation effort exceeding the insight).
The design balances accountability against practicality, and pairs cost measures with service and quality measures so that the incentive is to deliver the centre's purpose at the lowest cost, not to minimise cost alone. Cost centres are also the unit of cost reduction programmes: a review of each centre's activities, headcount, spend and output against its purpose, benchmarks and alternatives (shared services, outsourcing, automation).
A centre whose output can be bought for less than it costs is a candidate for outsourcing; one whose cost per unit of output has risen faster than its volume is a candidate for review.
In practice
Real-world examples.
Example
A factory's maintenance cost centre is measured on cost per machine hour maintained and on unplanned downtime, so that deferring maintenance to hit budget is visible.
Example
A hospital's pathology laboratory is a cost centre charging clinical departments per test, which reduced unnecessary test orders by 12% in its first year.
Example
A group's IT cost centre is converted to an internal service provider with unit prices per user and per application, and business units cut their consumption 15%.
Think of it
“A cost center is a department that spends money to support the business-measured on costs, not revenues.
Formula
Calculation
Cost Centre Variance = Actual cost minus Budgeted cost (adverse if actual is higher), analysed by cost line
Cost per Unit of Output = Total cost centre cost / Output units (invoices, tickets, employees served, units produced, hours)
Allocation to users = Cost centre cost x (User's share of the allocation base)
Flexed budget = Fixed budget element + (Variable cost per unit x Actual activity)
Worked example. A company's accounts payable cost centre.
Budget for the year: 4 staff $190,000; manager $70,000; software $36,000; postage and scanning $14,000; training $5,000; allocated occupancy $30,000; total $345,000. Budgeted volume: 36,000 invoices. Budgeted cost per invoice: $9.58.
Actual: staff $205,000 (an unbudgeted temp for four months to clear a backlog); manager $70,000; software $41,000 (an unbudgeted module); postage $11,000; training $2,000; occupancy $30,000; total $359,000. Actual volume: 41,000 invoices (a business acquisition added volume from month 5).
Variance against fixed budget: $14,000 adverse (4.1%). Flexed budget: staff and postage are semi-variable (each 1,000 invoices above 36,000 needs about 0.1 staff and $350 of postage); the flexed budget for 41,000 invoices = $345,000 + 5 x ($4,750 + $350) = $370,500. Against the flexed budget the centre is $11,500 favourable: it handled 14% more volume for 4% more cost. Cost per invoice: $8.76, down 8.6%.
Analysis by line: the temp ($15,000) was needed for the acquisition's backlog and is within the flexed allowance; the software module ($5,000) was bought without approval and is queried, though it automated matching and is credited with the lower postage and the absence of a second temp; training was cut, which the manager is asked to justify given the new module.
Service measures reported alongside: invoices paid on time 94% (target 95%); supplier queries 320 (target under 300); duplicate payments found by internal audit 3 ($4,100). The centre is efficient on cost and slightly below target on service; the report asks whether the training cut contributed.
Allocation onward: the $359,000 is allocated to the four business units by invoice volume: unit A 18,000 invoices (44%), $158,000; unit B 12,000 (29%), $105,000; unit C 8,000 (20%), $70,000; unit D 3,000 (7%), $26,000. Unit D's manager notes that its 3,000 invoices include 800 for one supplier that could be consolidated into 12 monthly invoices, which would cut its allocation and the centre's workload; the cost centre structure has made the cost of complexity visible to the person who can reduce it.
Outsourcing test: a shared-service provider quotes $7.20 per invoice for the same service with a 96% on-time target: $295,000 for 41,000 invoices against $359,000 in-house, a saving of $64,000 a year less transition costs of $50,000 and the loss of the flexibility the in-house team provided during the acquisition. The finance director decides to keep the centre in-house for a year with a target of $8.00 per invoice through further automation, and to revisit.Case study
Seen in the real world.
A manufacturing company ran its factory as a single cost centre with a budget of $18,000,000 and a manager who reported "within budget" each year. Product costs were built from a plant-wide overhead rate, and nobody could say what each of the four production lines, the maintenance department, the stores or the quality function cost. A new controller split the factory into nine cost centres with their own budgets, managers and output measures.
The first year's figures showed that line 3 cost 40% more per unit than line 1 to make similar products (older equipment, more scrap, more changeovers); that maintenance spent 60% of its hours on line 3; that stores held $2,000,000 of parts for equipment no longer in use; and that quality inspected line 1's output at three times the rate its defect record justified. Actions followed from visibility: line 3 was re-equipped, stores were cleared, inspection was rebalanced.
Total factory cost fell 9% in two years while output rose, and the product costs, now built from the cost centre where each product was made, showed that two products believed to be marginal were the most profitable and one believed to be the best was a loss-maker. The controller's summary was that the single cost centre had told the company only that it was spending $18,000,000, and that the nine told it where and why.
Watch out
Common mistakes.
- Judging a cost centre on cost alone, which rewards cutting service, quality and maintenance that other parts of the business then pay for.
- Comparing actual cost with a fixed budget when volume has changed; the flexed budget shows whether the centre was efficient at the volume it handled.
- Defining cost centres so coarsely that costs cannot be traced to where they arise, or so finely that allocation consumes the effort the visibility was meant to save.
Questions
People also ask.
What is the difference between a cost centre and a profit centre?
A cost centre is responsible for costs only and produces no revenue directly; a profit centre is responsible for both revenue and costs and is judged on the profit between them.
How are cost centre costs allocated to products?
Through allocation bases that reflect how products consume the centre's resources: machine hours, labour hours, headcount, floor space, transactions. The base should track the driver of the cost as closely as practical.
Can a cost centre be outsourced?
Any cost centre whose output can be defined and measured can be compared with an external provider's price and service. The decision weighs the cost saving against the flexibility, control and knowledge retained in-house.
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