Cost center is any part of an organization where costs are incurred and is only responsible for the costs that it incurs. Cost centers are not responsible for revenues, profits, or making capital investment decisions.
In most organizations, departments are considered as cost centers and the products or services produced by the organizations are called cost units.
However, if an organization wants to monitor and control its costs by going into more detail, it can define its cost centers at a lower level than a department. Here are some examples that an organization may consider as its cost centers:
- A department (responsible for costs incurred in the department)
- A machine (responsible for controlling the running costs of machine)
- A vehicle (for e.g., A passenger transport company may define each vehicle as cost center and driver of each vehicle as its manager responsible for costs such as fuel, maintenance etc.)
- A project (for e.g., development of a new product, construction of an office building, installation of an IT system etc.)
- A person (for e.g., Sales representative whose salary, traveling and meeting expenses, telephone cost need to be monitored and controlled)
Here is an explanation of why the concept of cost centers is used by organizations.
As organizations grow, it becomes impossible for the owners or higher management to directly monitor everything. In order to run the business efficiently and effectively, delegation of authority becomes inevitable.
Consequently, different sections or departments are made within an organization and tasks of the whole organization are divided among these departments. Each department is headed by a manager who has the direct responsibility for the department’s performance. These managers are given the authority to manage their departments, but at the same time, they are responsible for certain targets given to them.
Depending on the type of responsibility given to the managers, their departments or sections can generally be categorized as:
- Cost centers,
- Profit centers, OR
- Investment centers.
Where a department’s manager is only responsible for the costs incurred, that department is known as cost center. Usually, the higher management evaluate the performance of a cost center by comparing actual costs with budgeted costs. In case of cost over-runs, higher management will demand an explanation from the cost center manager.
Types and examples of cost centers
Cost centers can be classified into two types:
- Production cost centers which are directly involved in making a cost unit. For instance, a manufacturing department and a finishing department in a factory.
- Service cost centers which provide services to other business units. For instance, departments of Human Resource, Accounting, IT, Procurement, Canteen, Research and Development etc.
Costs incurred by service cost centers is transferred to production cost centers, and from there on, the costs are apportioned between different cost units of an organization.
Manager of a cost center will only be responsible for directly attributable costs. He should not be held accountable for the shared costs apportioned to his cost center. These apportioned costs should be traced back to relevant service cost center and the manager of service cost center should be responsible for such costs.
Profit centers and investment centers are explained in separate posts.
For those of you who get confused between the terms “cost center” and “cost unit”, you can go through our post “cost center vs. cost unit”.