Each week, our TechRepublic financial team answers your questions about the mysteries of making those budget sheets balance. This week, TechRepublic member asellers asked a question about cost centers.

Asellers: When I’m preparing requisition orders, I have to determine which “cost center” to charge. But often I’m buying networked equipment or servers that most everybody uses—that’s the idea of a network. What’s the business rationale behind “cost centers,” and how harmful is it to fudge a little when you’re not sure?

The Accountants: To answer this question, I first need to back up one level and explain the concept of “responsibility centers.” Every company needs a way to measure the financial performance of each part of the organization. That’s why financial departments set up responsibility centers.

The two main types of responsibility centers are “profit centers” and “cost centers.” A profit center is a division or department that has significant responsibility for both costs and revenue. A cost center, on the other hand, is a business segment that incurs costs, but doesn’t directly generate revenue or profit.
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How it works
Let me illustrate the concept of responsibility centers with a fictitious company, which we’ll call Ask the Budget Pro’s Accounting Accessories (ABPAA). ABPAA sells calculators and custom spreadsheet products to accountants. Our fictitious company has four major groups:

  1. The calculator division, which sells calculators to accountants
  2. The custom spreadsheet division, which sells custom spreadsheets to accountants
  3. Corporate IT
  4. Accounting

The managers of the calculator and custom spreadsheet divisions have significant control over the revenue generated from the sale of their products, as well as the costs associated with developing and marketing the products. So, these divisions would be considered profit centers. In some cases, a profit center may consist of a number of cost centers: The calculator division may, for example, have a marketing department, an R&D department, a manufacturing department, etc.

On the other hand, Corporate IT and Accounting are cost centers. Their function is essential to the operation of the entire organization, but they do not have any direct control over the company’s revenue.

In any case, both profit centers and cost centers are intended to do the same things—assign responsibility and accountability to the managers of each business segment, and provide a clear method of measuring the financial performance of the business segments.

Assigning the costs
The next question is what to do about activities and products, such as networked equipment and servers that benefit a number of different departments. The most important factor to keep in mind is that when accountants talk about responsibility centers from an accounting perspective, we’re talking about financial responsibility, not who benefits. For example, the marketing department generally has responsibility for advertising, but that’s an activity that benefits the entire company. They are the experts on marketing and advertising, so they should control those costs. But marketing’s ad campaigns bring visibility or awareness to the company in general.

Corporate IT is in a similar situation. They are the experts in setting the strategy for the corporate information infrastructure and therefore generally keep control of those costs, despite the fact that they incur those costs for the benefit of the rest of the organization. The financial responsibility for individual workstations often remains in the business units because their decisions and activities can impact workstation spending more than Corporate IT can. If a business unit goes over headcount or demands nonstandard equipment, then IT can hardly be held accountable for those costs.

Should I just stick this number anywhere?
You asked how harmful it is to fudge a cost center when you’re not sure. Let’s go back to the business rationale of responsibility centers—they are a way to measure the financial performance of each individual that is part of an organization.

By fudging a cost center, you are distorting the financial performance of two departments—the one that should have been charged and the one that did get charged. From an organizational perspective, this makes it very difficult to determine which business units are performing well and which ones are struggling. This may affect how resources are allocated in the future.

And if you look at this from your own personal perspective, you’ll want to assign the cost correctly because it may have an impact on your performance evaluation if you’re the manager in charge of a particular cost center.
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