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Cost centers are collecting places for costs before they are further analyzed. Costs are further analyzed into cost units once they have been traced to cost centers.
Costs consist of the costs of the following cost elements.
- Direct materials
- Production overheads
- Direct labor
- Administration overheads
- Direct expenses
- General overheads
When costs are incurred, they are generally allocated to a cost center. Cost centers may include the following.
- A department
- A machine, or group of machines
- A project (eg the installation of a new computer system)
Overhead costs eg rent, rates, electricity (which may then be allocated to departments or projects)
Cost centers are an essential 'building block' of a costing system. They are the starting point for the following.
Cost centers are an essential 'building block' of a costing system. They are the starting point for the following.
(a) The classification of actual costs incurred.
(b) The preparation of budgets of planned costs.
(c) The comparison of actual costs and budgeted costs (management control).
Revenue centers are similar to cost centers and profit centers but are accountable for revenues only.
Revenue center managers should normally have control over how revenues are raised. A revenue center manager is not accountable for costs. He will be aiming purely to maximize sales revenue. He will want information on markets and new products and he will look closely at pricing and the sales performance of competitors – in addition to monitoring revenue figures.
Profit centers are similar to cost centers but are accountable for costs and revenues.
We have seen that a cost center is where costs are collected. Some organizations, however, work on a profit center basis. Profit center managers should normally have control over how revenue is raised and how costs are incurred. Often, several cost centers will comprise one profit center. The profit center manager will be able to make decisions about both purchasing and selling and will be expected to do both as profitably as possible.
A profit center manager will want information regarding both revenues and costs. He will be judged on the profit margin achieved by his division. In practice, it may be that there are fixed costs which he cannot control, so he should be judged on contribution, which is revenue less variable costs. In this case he will want information about which products yield the highest contribution.
An investment center is a profit center with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment.
An investment center manager will take the same decisions as a profit center manager but he also has additional responsibility for investment. So he will be judged additionally on his handling of cash surpluses and he will seek to make only those investments which yield a higher percentage than the company's notional cost of capital. So the investment center manager will want the same information as the profit center manager and in addition he will require quite detailed appraisals of possible investments and information regarding the results of investments already undertaken. He will have to make decisions regarding the purchase or lease of non-current assets and the investment of cash surpluses. Most of these decisions involve large sums of money.
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