From Cost Center To Profit Center

Introduction

Organizations with decentralized operations structures typically divide their operations into cost or profit centers. It is a management and strategic decision for companies to decide which divisions should be cost centers and which ones should be profit centers. .

A cost center may actually provide services that could generate a profit if they were offered on the open market. But in most corporate environments, cost centers are not expected to generate a profit and operation costs are treated as overhead. Departments that are typically cost centers include information technology, human resources, accounting, and others.

Both cost and profit centers would add something to the bottom line of companies. Profit centers could generate profits for companies. Cost centers would reduce costs therefore increase profits for companies. Sometimes, a cost center in one company may be a profit center in some other company. Thus, a center that directly relates to the core competence of the company is usually a profit center and all other centers that do not have directly related to core business would be cost centers.

However, in recent year, more and more companies which have operated with cost centers in the past decide to change some or all of those cost centers to profit centers. They feel that these changes may generate more benefits for the organization in the long-run. This paper will discuss the difference between cost center and profit center and the reasons for conversion. It will introduce a success story; examine the considerations which must be taken into account when making this determination.

Definition

In business, an operating unit is either making money or it's detracting from a company's profits. Simply, this is the difference between a profit center and a cost center.

A cost center is a unit of an organization that generates expenses and has no responsibility for generating revenue. The only expectation a cost center has is to lower expenses whenever possible while staying with a specific budget that is determined at the corporate level. For example, the human resources department doesn’t earn revenue or profit and it should expense within the budget. As a result, the department is viewed as a cost center. IT department is another example of cost center for most companies.

In contrast, a profit center is a unit of an organization that generates both revenue and expenses. It is expected that, through the sale of goods or services, the unit will turn a profit. The goal for profit center is to have revenue exceed expenses. In other words, a business unit is regarded as a profit center when it has its own revenue and profit targets. Based on the definition above, profit centers should have following characterizes:

o Focus on market that are generating higher profits

o Create a portfolio of products and services driven by market demand.

o Price products and services at maximize profits.

o Quickly respond to market opportunity.

Reasons for conversion

Why do companies want to convert their cost centers to profit centers? Different companies may have different reasons.

Some companies want to keep their cost centers remain competitive with outside vendors providing same services. Normally, a cost center within a company provides service to other business units for free or only at cost. After the cost center converts into a profit center, the former cost center may be allowed to sell its services to other companies. Meanwhile, the company's other business units are then required to pay for the services they used to get for free or at lower cost. But in return, they are allowed to go outside the company and contract with another firm to provide those services. The expectation for this kind of conversion is that companies want this free market system will improve performance through increased competition.

Some companies want to reduce cost through conversions. When a company converts a cost center to a profit center, the profit center would no longer charge other business units fees for free or at cost. The center would charge them at market price which means fees would be higher than before. As a result, these units would reduce their cost by cutting their needless services. Therefore, companies would reduce cost as a whole.

In addition, some companies feel that their cost centers could be one of the best in the industry. If these cost centers convert into profit centers, they would generate profits when they provided services to outside companies. Meanwhile, companies could seek new revenue streams from these conversions.

Ways to convert

Mostly, IT department is set up as cost center in the company. The department may provide such services as computer-aided design, network administration, or database development to other units of the company. For example, IT department could charge human resource department for monthly maintenances fee. These services have value, and they are important to the company's overall success, but they do not generate a profit. IT may charge the "cost" of its services back to the department that requested them, but it does not make a profit because it charges only for its actual costs incurred, without adding an extra margin for profit.

How to convert IT department from cost center to profit center? There are two ways that could make the switch.

First, the IT department could be allowed to charge other departments for its services at market prices. The profit earned for the services would exceed the cost of providing the services. But all the money in this transaction would stay within the company, thus there is not a “real” profit for the company. If the IT department is turned into this type of profit center, it is considered to be a "zero profit center." In this situation, the department is expected to compete with outside vendors for the company's information technology budget. A division of the company would select the IT department as its technology provider only because it feels the services from IT department could compete with outside vendors at a lower price. Then, IT department will charge the division for the service. But the division will not actually "pay" the IT department for its services because the transaction is within the company and then no