Cost Units, Cost Centres, Profit Centres and Investment Centres
1 Introduction
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.
2 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
3 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.
Indirect cost is collected in a cost centre first, then allocated or apportioned as appropriate, and ultimately absorbed into cost units. A service cost centre supports production; it is not itself a final product cost unit.
4 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).
5 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.
Ask what the manager can control: costs only suggests a cost centre; revenue and costs suggest a profit centre; authority over assets or investment adds an investment-centre dimension. Avoid judging a centre solely by its title.
6 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
6.2 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.
6.3 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.
6.4 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 to 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.
Standard hours per unit = 2
Planned production = 5,000 units
Actual production = 5,200 units
Actual hours spent = 10,800
Efficiency ratio
5,200 units should take 10,400 hours (2 hours per unit)
5,200 units did take 10,800 hours
Production has therefore been inefficient.
The efficiency ratio is: standard hours for production achieved/actual hours
= 100 x 10,400/10,800 = 96%
Capacity utilisation ratio
Planned factory hours were 10,000 (2 hours x 5,000 units)
Hours worked = 10,800
More work has been squeezed out of the factory than expected.
The capacity utilisation ratio is: actual hours worked/budgeted hours
= 100 x 10,800/10,000 = 108%
Production volume ratio
Planned production = 5,000 units (or 10,000 hours)
Actual production = 5,200 units (or 10,400 hours)
Production has been higher than expected.
The production/volume ratio is: actual production/planned production
= 100 x 5,200/5,000 = 104%
[Note this could be also worked out using planned and actual hours (100 x 10,400/10,000)].
7 Performance measures appropriate to profit centres
Performance measures for profit centres include:
Profit compared to budget: Profit centres will usually have budgets to work to so this simple comparison is very useful.
Profit per unit: because a profit centre manager is responsible for costs and revenues, profit per unit produced or supplied is an obvious measure. A simple way to calculate this is to divide the profit for a period by the units produced in the period.
Gross profit percentage: this is the gross profit divided by sales and expressed as a percentage. It shows how many $s of gross profit are generated by each $ of sales. Gross profit can be thought of as the mainspring of profit generation.
Net profit percentage: this is the net profit divided by sales and expressed as a percentage.
Expenses/sales: these can be useful ratios to see if expenses (such as administration expenses) are keeping in line with sales.
$ | |
Sales | 1,800,000 |
Cost of sales | (800,000) |
Gross profit | 1,000,000 |
Expenses | (320,000) |
Net profit | 680,000 |
Gross profit % = 100 x 1,000,000/1,800,000 = 55.6%
Net profit % = 100 x 680,000/1,800,000 = 37.8%
Expenses compared to sales = 100 x 320,000/1,800,000 = 17.8%
8 Performance measures appropriate to investment centres
In an investment centre it will be important to try to judge how well managers have been able to generate profits from the capital invested in the investment centre.
Performance measures for investment centres include:
Return on capital employed (ROCE): this measure compares the profits earned by the investment centre to the capital invested in the investment centre. Return on capital employed is also known as return on investment (ROI). ROCE is rather like an interest rate: capital is invested in a bank account and income is then received.
Residual income (RI): this measure makes a notional charge to the investment centre for its use of capital. It takes the view that head office supplies divisions with capital and that capital has to be paid for. The residual income is what’s left if the division had to pay for its use of capital.
An amount of:
Capital employed x interest rate
is deducted from the division’s profits.
$ | |
Net profit | 680,000 |
Capital employed by the division | 4,000,000 |
Interest rate | 6% |
ROCE = 100 x 680,000/4,000,000 = 17%
RI = 680,000 – 4,000,000 x 6% = $440,000
9 Application of performance measures appropriate to cost, profit and investment centres.
Recent results of a division are:
$ | |
Sales | 5,000,000 |
Cost of sales | (3,000,000) |
Gross profit | 2,000,000 |
Expenses | (1,500,000) |
Net profit | 500,000 |
It had been budgeted to produce 100,000 units and these should have taken 5 hours each. In fact, 120,000 units were produced in 580,000 hours.
The capital employed by the division is $4,000,000 and the interest rate is 7%.
Calculate:
(a) Cost/unit
(b) Efficiency, capacity utilisation and production volume ratios or percentages
(c) Gross profit percentage
(d) Net profit percentage
(e) Expenses to sales ratio
(f) ROCE
(g) RI
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Cost Units, Cost Centres and Profit Centres
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