HOW A COMPANY CAN TURN A COST CENTER INTO A PROFIT CENTER
A profit center is a small unit of a company that generates revenue in excess of its expenses. It is expected that, through the sales of goods or services, the unit will turn a profit. This is in contrast to a cost center, which is a unit inside a company that generates expenses with no responsibility for creating revenue. The only expectation a cost center has is to lower expenses whenever possible while staying within a specific budget that is determined at the corporate level.
Beyond that simple definition, the term “profit center” has also come to represent a form of management accounting that is organized around the profit center concept. Companies that have adopted a profit center system have organized all of their business units as either profit centers or cost centers, and all company financial results are reported in that manner. Adopting a profit center system often requires a radical shift in corporate philosophy and culture, but it can yield great returns in net before tax (NBT) profits.
All companies, no matter what size, have both cost and profit centers (although if it is a single person company, that company would really have profit and cost activities, since all business “units” are the same person). For example, in most companies, units such as human resources and purchasing are strictly cost centers. The company has to spend money to operate those units, and neither has any means of producing a profit to offset those expenses. They exist solely to make it possible for other areas of the company to make money.
However, without those two departments, the company could not survive. Examples of profit centers would be the manufacturing units that produce products for sale to consumers or other businesses. The sale of those products generates a profit that offsets the expense of creating the products.
All companies have profit centers and cost centers, but not all companies organize their accounting practices around the profit center concept. In fact, most companies do things the time honored way, producing overall profit and loss statements for the company as a whole, without making each business unit accountable for generating a profit.
Turning a Cost Center into a Profit Center
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 operations costs are treated as overhead. Departments that are typically cost centers include information technology, human resources, accounting, and others. However, the complacent acceptance that some departments will always be cost centers and can never generate a profit has changed at some companies
They recognize that cost centers can turn into profit centers by taking the services they used to automatically provide to the company’s other business units and making those services available for a fee. The company’s other business units are then required to pay for the services they used to get for free. But in return, they are allowed to go outside the company and contract with another firm to provide those services. Likewise, the former cost center may be allowed to sell its services to other companies. The expectation is that this free market system will improve performance through increased competition while increasing profits by turning former cost centers into profit centers.
As an example of how a cost center may be turned into a profit center, consider a company’s information technology (IT) department. This department may provide such services as computer aided design, network administration, or database development to other units of the company. 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. The unit that requested the services absorbs the cost as part of its overhead; or, in some companies, the cost is not charged back and is simply part of the company’s overall overhead.
There are two ways that the IT department could make the switch from cost center to profit center. First, instead of writing off its services to overhead or charging them at cost, the IT department could be allowed to bill other departments for its services at going market rates. The profit earned for the services would exceed the cost of providing the services. While all the money in this transaction would stay within the company, thus making it seem to be a meaningless way of creating a profit for the IT department, it is done for two reasons.
One is to ensure that the IT department remains competitive with outside vendors providing the same services, and the other is to ensure that the company’s other business units do not waste money on needless IT expenditures. Paying competitive market rates prevents the operating units from wasting money, thus making them more competitive.
If the IT department is turned into that type of profit center, it is considered to be a “zero profit center.” In that situation, the department is expected to compete with outside vendors for the company’s information technology budget. If a division of the company selects the IT department as its technology provider, it has done so because it feels it cannot purchase that same quality services for a lower price from an outside vendor. It will not actually “pay” the IT department for its services, but it will be charged by the IT department for services rendered, and those charges will be subtracted from the division’s budget.
Thus the IT department does not really take in any revenue, but neither does it cost the company any money because the division that utilized its services would have had to spend money to hire an outside vendor. This, then, creates a zero profit center. Such a business model forces the IT department to be more competitive in its pricing and to provide high quality work if it hopes to survive as an operating unit.
The second way the IT department could become a profit center is if the company determined that the department was one of the best in the industry, better in fact than some companies that existed just to provide IT services. The company could then allow the department the freedom to sell its services to outside customers. Thus, the department could still operate as a cost center in its dealings with other units inside the company, but it would operate as a profit center when it provided services to outside companies. This method of operation has become common as companies seek new revenue streams that have low startup costs.
If the IT department exists only as a cost center, it faces enormous pressure to provide services at the lowest possible costs. Because it does not generate profits, it must constantly fight to remain in existence and must fight off attempts to slash its budget to free up cash for the company’s profit centers. Just as the company’s senior management could decide that the IT department was good enough to operate as a profit center by soliciting outside clients, so too could it decide that the department is behind the times and is not providing adequate services. This would result in management choosing to shut down the department and contract with an outside vendor for the company’s IT needs.
Profit Centers and Small Businesses
When operating a small business, it may not be practical to use the profit center concept initially because the business is so small. Fewer employees mean fewer business units, which mean fewer opportunities to create profit centers. In addition, in a small business, the president or the chief financial officer is probably monitoring financial results very closely, which means that he or she knows exactly where profits and losses are occurring. However, as a small business begins to grow, establishing profit centers often make sense. Even without adopting the profit centers accounting concept, the idea of profit centers has value for small businesses in that they should always be looking for ways to generate revenue.
When operating a small business, there are essentially two ways to create a new profit center. The first method is to create an extension of the original business; a new product related to existing products, or new services that build on services that are essentially offered. The second method is to create an entire new business altogether that can operate using the first business’s corporate infrastructure (at least initially) and that can be operated at the same time as the original business.
When seeking new profit centers, small business entrepreneurs should avoid business models that have regularly failed on the Web. These include setting up an entertainment site that attempts to charge a fee for that entertainment; relying on advertising as a revenue stream, as banner advertising are proving to be quite unsuccessful in bringing in new customers; charging subscription or other visitor fees; and biting more than you can handle by attempting to establish business to business sales that may not be achievable.
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