What is a Cost Centre in Accounting?
A cost centre can be defined as a department or function within a business that incurs costs to the company, but does not directly contribute towards generating revenue for the company.
In other words, a cost centre is a part of a business that is responsible for expenses such as salaries, rent, utilities, and other overhead costs.
The expenditure from cost centres will directly impact the businesses’ profitability. Therefore, from an accounting perspective, it is extremely important that these costs are monitored and evaluated.
Generally, this is done by using an accounting system where cost centres are usually given a unique code in which all costs are coded to.
This provides visibility for the business to clearly view what costs incurred relate to each specific cost centre.
Breaking down a business’s divisions into cost centres allows for a more effective control and evaluation of the total costs incurred by the company.
This method makes it clear and easy to see what is being spent in each area of the business.
The performance of a cost centre is usually monitored by comparing the actuals costs for the month to the budgeted costs.
The responsibility of controlling these costs falls to the management of the individual cost centre. The accounting function would typically report these numbers back to the cost centre managers as part of each month end.
Cost Centre Example
In a business context, cost centres are usually departments within the company, and some examples would include:
- Finance
- IT
- Human Resources
- Office Maintenance
- Research and Development
- Payroll
- Customer Service
These departments may not directly generate revenue for the business, but they are necessary for the business to function effectively.
Each cost centre would be ‘owned’ by someone in that department, usually the head of the department, and it would be their responsibility to control and monitor the costs incurred.
They would also usually have monthly meetings to compare actual costs to budget, and explain any variances to senior management.
Sometimes, larger projects within the business would have their own cost centre, to track and manage the costs from the start of the project to it’s completion.
Cost Centre Types
There are typically six cost centre types found in organisations as explained below:
Personal
A personal cost centre is associated with a specific individual or group of individuals within a business.
The costs associated with this type of cost centre are generally related to employee compensation, benefits, and training. An example of a personal cost centre would be the payroll department of a company.
Impersonal
An impersonal cost centre is not associated with any specific individual or group of individuals.
The costs associated with this type of cost centre are typically related to overhead expenses such as rent, utilities, and office supplies.
An example of an impersonal cost centre would be the rent and utilities associated with the office building of a company.
Operation
An operation cost centre is a department or function within a business that is responsible for carrying out specific operations or activities.
Operation cost centres aim to establish the cost of each operation, irrespective of the location or department within the business.
Examples of operation cost centres can vary depending on the nature of the business. For a manufacturing company, the production department would be an operation cost centre, responsible for the production of goods, and incur costs such as raw materials, direct labour, and overhead expenses such as rent, utilities, and equipment maintenance.
In a retail business, the sales department would be an operation cost centre. They would be responsible for generating revenue through the sale of goods, and incur costs such as sales personnel salary, sales commission, advertising, and other promotional expenses.
Product
A product cost centre is associated with a specific product or group of products within a business. The costs associated with this type of cost centre are related to the production and distribution of these products, such as raw materials, labour, and shipping costs.
An example of a product cost centre would be the production and distribution of a specific product line within a manufacturing company. For example, in a furniture manufacturer, there may be a product cost centre for tables, and another one for desks.
Service
A service cost centre is associated with a specific service or group of services within a business.
The costs associated with this type of cost centre are related to the resources required to provide these services, such as labour, equipment, and supplies.
An example of a service cost centre would be the IT department of a company that provides technical support and maintenance services to other departments.
Process
A process cost centre focuses on a specific process within the business. For example, this could be the process of sending items to customers, or cleaning an aeroplane after each flight.
The costs associated with a process cost centre are related to the resources required to carry out this production process, such as labour, materials, and energy.
What Are The Benefits of Having a Cost Centre?
There are several benefits of having cost centres, including:
- Help Track Expenses: By tracking expenses at the cost centre level, businesses can get a better understanding of where their money is being spent. This information can be used to make informed decisions about where to cut costs or where to invest in new resources.
- Improve Decision Making: By allocating costs to specific cost centres, businesses can see which areas are generating the most expenses. This information can be used to make better decisions about resource allocation and process improvement.
- Enhance Accountability: When expenses are tracked at the cost centre level, managers and employees become more accountable for their spending. This can help reduce waste and improve financial discipline within a company.
Identifying and Allocating Costs
To effectively use cost centres for financial management, they must be appropriately allocated to each department or function.
There are two main methods of cost allocation: direct and indirect costs.
Direct costs are expenses that can be directly traced to a specific cost centre. For example, the salary of a customer service representative would be a direct cost for the customer service department.
Indirect costs, on the other hand, are expenses that cannot be directly traced to a specific cost centre.
Examples of indirect costs might include rent, utilities, or IT support. These costs need to be allocated to different cost centres based on some predetermined method, such as square footage or number of employees.
How To Manage a Cost Centre
Managing a cost centre involves several key steps:
Define the Cost Centre
First, the cost centre needs to be defined. This involves identifying the specific department or function that the cost centre will cover and the types of costs that will be associated with it.
Allocate Costs
Once the cost centre has been defined, costs can be allocated there. This involves identifying the costs that are directly related to the cost centre, and also allocating any indirect costs based on a predetermined method.
Set Budgets
With the costs allocated, budgets can be created for each cost centre. This involves estimating the costs for the upcoming period and setting a budget target that aligns with the overall goals of the business.
Monitor Expenses
Throughout the budget period, costs incurred to each cost centre should be closely monitored and evaluated. This involves comparing actual expenses against the budgeted targets and identifying any reasons for variances.
Adjust Budgets
If costs are higher than the budgeted objectives, then the budget may need to be adjusted or cost savings will need to be found. This could involve renegotiating contracts, reducing staff, or finding more efficient ways of working.