Cost centres, Profit and Investment Centres

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Introduction to Cost Units, Cost, Profit and Investment Centres

This chapter looks at how costs can be traced to production and to locations within an entity, and how the performance of those units can be appraised.

Cost units

A cost unit is a unit of a product or a service to which costs can be traced.

For example, for a manufacturer of laptop computers, a cost unit would be a laptop. For a bus company, a cost unit could be a bus journey.

It is important to be able to identify cost units to be able to:

• Work out the cost of providing that product or service
• Work out the resources needed: material, labour and other expenses to make or supply the unit.
• In a profit-seeking organisation, to decide on a selling price that will allow a profit to be made
• In a not-for-profit organisation, to plans to be made as to where to spend resources.
• Control the use of resources by comparing actual costs to budgeted costs

Cost centres

A cost centre is a place to which costs can be traced or segregated.

A cost centre could be:

• A subsidiary company
• A division
• A department
• A team
• A person
• A production line
• A project
• A machine

The head of a cost centre will be responsible for costs only: not revenue or profits

Examples of cost centres can include: the IT department, quality control department, the accounting department, the manufacturing facility.

Profit centres

A profit centre is a place where both costs and revenues are identified.

As above, a profit centre could be:

• A subsidiary company
• A division
• A department
• A team
• A person
• A production line
• A project
• A machine

The difference is that here, in addition to being responsible for costs, the head of a profit centre will also be responsible for revenues.

The revenues could be sales to outside organisations or they could be internal sales to elsewhere in the organisation. For example, an IT department could be turned from a cost centre into a profit centre if it were to be allowed to charge IT users for the services supplied.

Being head of a profit centre is usually more interesting and demanding than being just the head of a cost centre. Many people don’t get great satisfaction from ensuring that costs do not exceed budget (a cost centre manager’s responsibility), but would get much satisfaction from beating a profit budget (a profit centre manager’s responsibility).

Investment centres

An investment centre is a place where costs, revenues and capital investment are identified.

Because costs, revenue and capital expenditure all have to be identified separately an investment centre would normally be:

• A subsidiary company
• A division

The head of an investment centre will be responsible for costs revenues and capital expenditure. In effect, that person has responsibility for all financial aspects of the investment centre.

Performance measures appropriate to cost centres

It is important to monitor the performance of cost, profit and investment centres to judge how both the centres are performing economically and how their managers are performing as managers. It is important not to judge managers for elements of performance for which they have no responsibility.

Performance measures for cost centres include:

• Cost compared to budget
• Cost/unit
• Efficiency, capacity utilisation, and production volume ratios

Cost compared to budget:

Cost centres will usually have budgets to work to so this simple comparison is very useful. However, it says nothing about what the cost centre achieved: it could spend 10% less than budget but produce only 50% of the output expected.

Cost/unit:

Since a cost centre manager is responsible for costs, cost per unit produced or supplied is an obvious measure. A simple way to calculate this is to divide the costs incurred in a period by the units produced in the period.

Efficiency, capacity utilisation and production volume ratios

These relate to the use of time (and hence labour costs) in the cost centre.

When setting a budget for a cost centre, it is normal to specify how long it should take to produce each item (standard hours/unit) and how many hours the factory is expected to work.

For example, if each unit should take 2 hours to make, and output is planned to be 5,000 units in a period, then the planned factory hours will be 10,000. Here, 10,000 is said to be the capacity of the factory ie the hours it was expected to work.

A number of things can happen these plans:

• Producing the units might not take the standard hours per unit. This will give an assessment of efficiency.
• More or fewer hours might be worked in the factory than originally expected. This will give an assessment of capacity.
• More or fewer units might be produced than budgeted. This will give an assessment of production volume.

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