Cost Center Definition: How It Works and Example

What Is a Cost Center?

A cost center is a department or function within an organization that does not directly add to profit but still costs the organization money to operate. Cost centers only contribute to a company's profitability indirectly, unlike a profit center, which contributes to profitability directly through its actions. Managers of cost centers, such as human resources and accounting departments are responsible for keeping their costs in line or below budget.

How a Cost Center Works

A cost center indirectly contributes to a company’s profit through operational efficiency, customer service, or increasing product value. Cost centers help management utilize resources used. Although cost centers contribute to revenue indirectly, it is impossible to discern the actual revenue generated. Any associated benefits or revenue-producing activities of these departments are disregarded for internal management purposes.

Cost centers are often assigned their own general ledger coding that management and personnel can use to absorb and report costs. As budgets are prepared, cost centers are intentionally forecast to operate as a loss; in fact, budgeted revenue will be $0. Instead, management's goal is to minimize the deficit of a cost center while still providing general support to profit centers.

Purpose of a Cost Center

The main function of a cost center is to track expenses. A cost center manager is only responsible for keeping costs in line with the budget and does not bear any responsibility regarding revenue or investment decisions. Cost centers provide metrics more relevant to internal reporting. Internal management utilizes cost center data to improve operational efficiency and maximize profit.

External users of financial statements, including regulators, taxation authorities, investors, and creditors, have little use for cost center data. Therefore, external financial statements are generally prepared with line items displayed as an aggregate of all cost centers. For this reason, cost-center accounting falls under managerial accounting instead of financial or tax accounting.

Expense segmentation into cost centers allows for greater control and analysis of total costs. Accounting for resources at a finer level such as a cost center allows for more accurate budgets, forecasts, and calculations based on future changes.

Types of Cost Centers

Companies can opt to segment out cost centers however they choose, as the end goal of a cost center is to isolate information for better internal data collecting and reporting. Here are several common types of cost centers along with examples of each.

Operational Cost Center

Operational cost centers group people, equipment, and activities that engage in a singular commonly-themed activity. Most often, operational cost centers may be seen as common company departments that group employees based on their function within the company. The important part to note is an operational cost center is a back-office function that, while it may represent an entire department, does not generate revenue.

Example of Operational Cost Center: IT Department (employees, hardware, and software)

Personal/People Cost Center

Personal cost centers break out a collection of individuals. As opposed to the IT department above, a personal cost center would exclude physical materials. This type of cost center allows a company to isolate only the cost of headcount without being distorted by equipment, materials, or other goods.

Example of Personal/People Cost Center: HR Department (excluding HR software)

Impersonal/Machinery Cost Center

On the other hand, an impersonal/machinery cost center isolates the costs of all non-employee costs. A company may be interested in only viewing the upfront cost, maintenance expenses, repair requirements, and other costs related to just the heavy machinery for a process. This type of cost center may coincide with other types of cost centers, as companies may want to know the non-personnel cost of a specific department, for example.

Example of Impersonal/Machinery Cost Center: Manufacturing Plant (omitting headcount)

Locational Cost Center

A more specific type of impersonal cost center may define a geographical location for a cost center. A company may decide it wants to include or exclude the cost of employees for a certain region. In addition, be mindful that a locational cost center must also exclude revenue even if revenue is generated in the region. The sales of that region would simply be reported in a different profit center.

Example of Locational Cost Center: IT Department, Northwest Operations (Washington, Oregon, Idaho)

Product Cost Center

Though it may be referred to as a research and development center, a product cost center aggregates the costs associated with developing, constructing, and bringing a product to market. It often excludes the operational costs needed to facilitate the sale of the product (as these costs often want to be reported against revenue).

Example of Product Cost Center: 14th Generation of Apple iPhone (prior to market delivery)

Project Cost Center

On a very similar note, a company often decides to segregate out costs for a project or service-driven endeavor. This project may simply be a capital investment that requires tracking of a single purpose over a long period of time. This type of cost center would most likely be overseen by a project management team with a dedicated budget and timeline.

Example of Project Cost Center: Corporate Warehouse Development Projects

Service Cost Center

A service cost center groups individuals based on their function and may more closely refine the costs within a department. For instance, a company may feel an IT department is too large of a cost center and may want to break out employees by more dedicated services. Companies may opt to include or exclude the costs necessary for the service cost center to be successful.

Example of Service Cost Center: Janitorial Staffing (as a subset of the Facilities Department)

Benefits of a Cost Center

Running a cost center is a logistical burden that requires a company to perform potentially extra work to track, collect, and analyze information. However, there's plenty of reasons why a company would still choose to do so, and each of the benefits highlighted below are reasons why cost centers can be invaluable to the long-term success of a company.

Greater Fiscal Responsibility

At the heart of cost centers is the notion of fiscal responsibility, the idea that different groups of individuals should be responsible for the financial outcome of their area. By separating out groups, even groups that do not make money, department leaders are put in charge about managing their team's finances. It is acknowledged upfront that a cost center will be unprofitable; however, a manager can still be held accountable to the degree at which they operate at a loss.

Better Customer Experience

Cost centers may be devised to specialize in their one particular area. For this reason, instead of having to juggle multiple competing priorities that detract resources from certain areas, cost centers can focus on what they do best. This means service departments that interact with customers can prioritize the service they deliver and not need to worry about the financial implications of needing to generate a profit.

Smarter Decision-Making

With greater insights into the financial aspects of different areas of their company, upper management can use cost center data to make better decisions. This includes a better understanding of what costs it may take to scale operations to target revenue levels, how a merger may impact company profits, or what targets are most reasonable for a long-term strategic plan.

More Transparent Operational Shortfalls

On a related note, cost centers may also identify where current deficits exist and more resources need to be delivered. Companies can compare cost centers from different regions or teams to better understand the resources successful cost centers have and how they need to better support other areas.

Cost Center and Cost Allocations

In financial management, most companies will decide to assign expenses to specific departments, projects, or units within an organization. This practice allows businesses to track and manage costs more accurately, though this does mean it needs a deliberate way of allocating expenses to each department, some of which may be cost centers.

The process of allocating costs typically involves identifying direct and indirect costs associated with each cost center. Direct costs are those that can be directly traced to a specific cost center such as salaries of employees working in a particular department. Indirect costs can be allocated in a few different ways:

• Step-Down Method: In this approach, indirect costs are allocated sequentially, starting with the cost center that provides the most services to other cost centers. Each cost center’s costs are allocated to other cost centers before moving on to the next.
• Activity-Based Costing (ABC): This method allocates indirect costs based on activities that drive costs. Each activity’s cost is assigned to cost centers based on their usage of these activities. For instance, machine maintenance costs are allocated based on machine hours used by each department.
• Proportional Allocation: Costs are allocated based on a proportional factor, such as the percentage of total labor hours, square footage occupied, or number of employees. For example, rent costs could be allocated based on the square footage each department occupies.
• Dual-Rate Method: This involves splitting indirect costs into fixed and variable components. Fixed costs are allocated based on a predetermined base (e.g., budgeted usage), while variable costs are allocated based on actual usage.
• Reciprocal Method: This method simultaneously allocates costs of service departments that provide services to each other and to other departments, considering the mutual services exchanged among service departments. This is typically done using matrix algebra or iterative calculations.

Limitations of Cost Centers

One significant limitation is that cost centers typically focus solely on costs and not on revenues. This narrow focus can lead to an incomplete picture of an organization's financial health. For instance, think of all the ways a company can generate revenue by spending money; without some sort of view of revenue in association with costs, cost center performance can be misleading.

Another limitation is the potential for inefficiencies in resource allocation. Cost centers often allocate costs based on predefined criteria, such as headcount or square footage, which may not always reflect the actual usage or benefit derived from shared resources. Additionally, the process of allocating indirect costs can be complex and time-consuming.

Cost centers can also create a silo mentality within organizations. By segmenting expenses into distinct units, departments may become more focused on their own budgets and cost-saving measures, potentially leading to a lack of collaboration and coordination across the organization. The emphasis on cost control can also stifle creativity and risk-taking, as managers might be more inclined to prioritize short-term cost reductions over long-term strategic investments.

Last, cost centers do not inherently provide insights into the profitability or value generation of specific activities. While they can highlight where costs are incurred, they do not offer a comprehensive view of how these costs translate into business outcomes. This can make it challenging for managers to evaluate the true performance and contribution of different parts of the organization, as spend doesn't simply tell the entire story.

The Bottom Line

A cost center is a collection of activities that management wishes to track as a group to better understand the expenses necessary to support an organization. Unlike the investment centers of the business, the cost centers do not earn money, but they are critical parts of helping the company run and often can not simply be eliminated.

By breaking out cost center activities, a company can gauge the cost of administrative operating the business.