For any business, it is important to have an understanding of how much it costs to run various parts of the company, for example, a department or a machine in that department. Without this specific knowledge, the business might find itself subsidising loss-making departments or machines without knowing it. In other words, the loss made by a particular cost unit is compensated for by the profits of other units.
Knowing which parts of the organisation are profitable and which run at a loss makes it possible to cut out loss-making units.
Cost centres are part of the organisation structure of the business. Costs are related to the department or section of the organisation that incurs them.
A cost centre is a location, function or items of equipment in respect of which costs may be ascertained and related to cost units for control purposes.
A printing firm has printing presses costing £1m each. It may be decided that each machine is to be a cost centre.
A television company consists of a number of departments including make-up, programming, advertising, and public relations. It is decided that each of these departments will be a cost centre.
As well to using cost centres another important way of costing is to determine the cost per unit of production or sales. For example, in a printing firm producing books, each book can be counted as a cost unit.
The purpose of a costing exercise is to determine the cost of a cost unit, therefore all costs should be allocated to cost units whenever possible. Only when costs cannot be attributed to a specific product are they to be charged to a cost centre – for example, take two costs incurred in a workshop of a garage, the wages of a mechanic working on customers’ cars and the cost of electricity used for powering workshop tools and lighting. The wages of the mechanic can be identified with cost units provided a record is kept of how time has been spent, e.g. by each repair or service job, but it is not practical to record the electricity attributable to specific jobs. This cost should be allocated to the cost of running the workshop (i.e. it is a cost centre cost).
If we can break up an organisation into cost centres to see how much machines, departments, or other components cost to operate we can also divide the organisation into profit centres.
In a profit centre, we will need to look at the costs associated with running that centre and the revenues to calculate the profit. For example, an organisation like the BBC can be split into profit centres and each can set profit targets to work towards. Dividing an organisation into profit centres makes it possible to identify the parts of the organisation that generate the profits and the parts that do not.