What it means
A company is easier to manage when its costs are grouped into areas of responsibility. A cost centre is one such area, with a named manager, a budget and regular reports showing actual spending against plan.
Unlike a profit centre, which earns revenue and is judged on profit, a cost centre is judged on whether it delivers its service efficiently and within budget. A payroll team that processes salaries accurately for less money than last year is doing a good job even though it brings in no sales.
Costs are normally coded to the cost centre when they are incurred, using a general ledger code. A software subscription bought by the marketing team is charged to the marketing cost centre, and a recruiter's salary is charged to the human resources centre.
Many organisations then allocate the cost of support centres to the departments that use them. IT costs might be shared by headcount, and office costs by floor area.
This shows the full cost of running each revenue-generating division, though the allocation method should reflect real usage to be fair. Cost centres bring accountability but also risks.
Managers may rush to spend their entire budget at year end to avoid a cut, or avoid spending on useful items because the cost lands on their report. Good practice is to review budgets against outcomes rather than simply against last year's total.
Some businesses go further and run a cost centre as an internal service with a transfer price, charging other departments for what they use. This brings discipline, since the users must justify the demand, but it also adds administration and can lead to disputes over rates.
In practice
Real-world examples
Example 1
A law firm treats its library and research team as a cost centre. The firm tracks the annual budget of $350,000 and asks the head of knowledge services to explain any overspend. A quarterly review compares the spending with the number of research requests handled.
Example 2
A manufacturer sets up a quality assurance cost centre and charges its costs to each production line by the number of batches tested. Line managers then see what testing adds to the cost of their products.
Example 3
A university's student services department is a cost centre funded from the central budget. The dean reviews its spending against student satisfaction results, not against revenue. If satisfaction rises while costs stay level, the department is judged to be performing well.
Think of it
A cost center is a department that spends money to support the business-measured on costs, not revenues.
Formula
Calculation
Allocated cost = total cost centre cost x (department's share of the allocation base / total allocation base)
An IT cost centre spends $600,000 in a year and allocates it by headcount. The sales department has 40 staff, operations has 60 and finance has 20, making 120 in total. Sales is charged $600,000 x 40 / 120 = $200,000, operations is charged $600,000 x 60 / 120 = $300,000 and finance is charged $600,000 x 20 / 120 = $100,000. The three charges add up to $600,000, so the whole cost is allocated.Case study
Seen in the real world
Greystone Logistics is an illustrative, fictional freight company whose head office departments had grown to cost $4,500,000 a year. Managers complained about the charge they received, which was split equally between five regional divisions, even though the regions used the central services very differently.
The finance director changed the allocation base. Costs for IT were split by number of users, fleet administration by number of vehicles and human resources by headcount, so each region was charged for what it actually consumed.
One region found it was paying $400,000 less than before while another paid $350,000 more. In this illustrative case, the fairer allocation prompted the busiest region to question its own use of central services and cut requests it did not need.
Watch out
Common mistakes
- Treating a cost centre as unimportant because it does not earn revenue, when its efficiency can strongly affect profit, because a bloated support function drags down the profit of every division it serves.
- Allocating costs using an arbitrary base, such as equal shares, which misleads managers about their divisions' profitability and can lead to poor decisions about which divisions to grow or close.
- Judging cost centre managers only on staying under budget, which can encourage cuts to useful spending.
Questions
People also ask
What is the difference between a cost centre and a profit centre?
A cost centre is measured on spending and efficiency, while a profit centre is measured on the profit it makes from its own revenue and costs.
Can a cost centre ever become a profit centre?
Yes, if it starts selling services externally or charges other units at market-based transfer prices, it can be assessed on profit. Some companies do this with their IT or training teams.
Who is responsible for a cost centre?
A named budget holder, usually a department head, who approves spending and explains differences from budget. Finance supports with monthly reports and forecasts.