cost centres and profit centres

lgarside

Hello can someone give me a few examples of each and show how they would be in a manufacturing industry and also in a service industry. I'm so confused with these!!!!

Also if you had rent would this go to the cost and profit centres?

Thanks for your help

SandyHood

I thought I'd start by listing some related threads (and the first was yours on the Technician board)
http://www.aat.org.uk/forums/showthread.php?t=16674&highlight=profit+centres

http://www.aat.org.uk/forums/showthread.php?t=13983&highlight=profit+centres
http://www.aat.org.uk/forums/showthread.php?t=10221&highlight=profit+centres

Sometimes it is easier to use an example to explain these terms, and I would expect your examiner to appreciate and reward you if you explain terms by putting them into context.

In my area there is a very good chocolate manufacturer http://www.montezumas.co.uk
This company have a relatively small factory where the chocolates are made, a fleet of delivery vehicles, a sales office dealing with internet and mail order sales and 8 shops.

Without knowing how the departments are divided up for accounting purposes, I will guess.
Factory
Here the raw materials are delivered and the chocolatiers make the chocolate products. There are no doubt very many invoices for all sorts of things, rent of premises, heat and light, cleaning materials, raw choicolate and related ingredients, and wages to name just some. Nothing is sold out of the factory.
Delivery vehicles
The chocolate products are transported by the vehicles from the factory to shops and customers. Again, no doubt there are vehicle related costs and wages and there may be other things that haver to paid for. Nothing is sold by the drivers of these vans, even if they are delivering to a customer the chocolate will have already been paid for online or by cheque.
Sales office
Here internet, postal and telephone orders are collected. The neccessary products are transferred from the factory and then dispatched to customers. The staff have to be paid, the office needs to have telephone and internet connections (again at a cost) stock transferred in from the factory is a cost of the department. But they also have revenue, the money received from customers buying the chocolate by mail order.
Each shop
Has costs, rent wages, chocolate transferred in etc and revenue, the customers' money when they buy the chocolate.

lgarside
I haven't answered exactly the question you posed but before I give you a drier reponse, please stick with this and answer my questions.

Profit centres are departments within the organisation where revenue and costs are accumulated
Cost centres are similar, but cannot have any revenue, so only costs are accumulated


State whether the following are cost centres or profit centres in the Montezuma's example:-

1. Factory
2. Distribution fleet of vans
3. Mail order sales office
4. Shop 1 Lichfield
5. Shop 2 Winchester
6. Shop 3 Spitalfields London
7. Shop 4 Chichester
8. Shop 5 Brighton
9. Shop 6 Newbury
10. Shop 7 Windsor
11. Shop 8 Kingston upon Thames

lgarside

profit and cost centres

Thanks so much for your help Sandy, I feel so stupid as this is really basic stuff but I just can't get my head round it and the books don't really give you any examples.

So to answer the Qu the first three are cost centres and the last 8 are profit centres? If this is correct then that is why I was getting confused because someone said the production line i.e where they make the chocolates is the profit centre, which in this example is wrong.

SandyHood

State whether the following are cost centres or profit centres in the Montezuma's example:-

1. Factory
2. Distribution fleet of vans
3. Mail order sales office
4. Shop 1 Lichfield
5. Shop 2 Winchester
6. Shop 3 Spitalfields London
7. Shop 4 Chichester
8. Shop 5 Brighton
9. Shop 6 Newbury
10. Shop 7 Windsor
11. Shop 8 Kingston upon Thames

Answers

1. Only has costs, no revenue - A cost centre
2. Only has costs, no revenue - A cost centre
3. Has costs and revenue - A profit centre
4. Has costs and revenue - A profit centre
5. Has costs and revenue - A profit centre
6. Has costs and revenue - A profit centre
7. Has costs and revenue - A profit centre
8. Has costs and revenue - A profit centre
9. Has costs and revenue - A profit centre
10. Has costs and revenue - A profit centre
11. Has costs and revenue - A profit centre

So you are almost completely right. Anywhere where there is only expenditure is a cost centre. If there is income AND expenditure it is a profit centre.

And as a little extra, even if the expenditure in one shop is greater than the income that shop is still a profit centre abeit a negative profit (or a loss) centre in fact.

lgarside

Thanks sandy so when you allocate overheads do they go to the profit centres aswell or just the cost centres? for example the rent and rates of each shop do these just get allocated to each shop and they don't worry about absorbing this into i.e the production line for each box of chocolates made? You only absorb the overheads of the cost centres?

SandyHood

That would be a matter of company policy.
If it was my decision, I would not even try to charge costs attributable to the shops as part of the cost of the chocolates.
Instead I would build in a margin on top of the factory cost and expect the margin to allow enough to pay all the shop costs and produce a profit.
This way I could have a profit and loss account for each shop and the managers of each could then have clear profit targets that are fairly transparent.

lgarside

Fantastic, thanks so much for your help sandy it makes much more sense to me now. So the allocation of costs is purely the costs from the cost centres involved in the product, I guess I'm right in assuming this would inc things like marketing and accountany departments as these aren't profit centres. SO in manufacturing if you had a sales shop (profit centre) you wouldn't try and absorb these costs into the product but for a HR department (cost centre) you would.

In a service industy, say a hospital would you have a profit centre, or not because they don't make a profit?

SandyHood

My example didn't include the accounts department or HR but as you quite rightly have identified these are departments where costs are incurred but there is no revenue (cost centres).
You can do as you have suggested, but to be honest I have not worked for organisations that have done that.
I would tend to cost the products on the basis of:

1. direct materials
2. direct labour
3. direct expenses
4. absorbed production overhead
   To give me a cost of the product
5. Then an arbitrary mark up for non-production overhead
6. And finally a profit margin
   To give the selling price

You have probably studied 6.2 on overheads, and to try to put an accurate cost onto a product for the HR dept or the accounts dept is involved so it would take time, and is likely to be flawed in terms of accuracy.

There are ABC systems that try, but ABC is not a major topic even at technician level AAT.

I think you should settle for the product cost coming from the production costs, and then make sure the price has a big enough margin to be able to cover the non-production overheads and a profit.

SandyHood

Your hospital question is rather like one of the link topics.

Some hospital departments have income (invariably) from the Dept of Health. So they would be profit centres, for example a paricular ward will have funds allocated on the basis of the number of patients or bed nights I am out of my area of expertise so please correct me if you know better - a number of St Richards Hospital accounts staff have been in my class over the years so I have a grasp of the basics

Other depts including finance do not have income so are cost centres

SandyHood

I was asked by a student recently if he should label a department which costs the business because the revenue is not as much as the expenditure a cost centre. I think you probably know my answer already. NO
If a department has revenue and expenditure it is a Profit centreIt just so happens that it isn't making a profit!

lgarside

costing and service centres

Hi Sandy just have a quick question for you. In my book it shows you how to reallocate e.g the costs of the canteen back into production to get the unit cost. It also shows in some of the examples that they just add back say 20% of the production overhead to cover the cost of the canteen. Would you do this instead of reapportioning the costs back into production or have I got totally confussed!?!?! Am I right in thinking you won't be expected to work out this % in the exam they will just give you the fig to use?

Once again thanks for your help

SandyHood

Igarside
I have assumed that in your latest posting you are thinking about the ECR exam and simulation questions.

1. In my book it shows you how to reallocate e.g the costs of the canteen back into production to get the unit cost.
2. It also shows in some of the examples that they just add back say 20% of the production overhead to cover the cost of the canteen. Would you do this instead of reapportioning the costs back into production
3. Am I right in thinking you won't be expected to work out this % in the exam they will just give you the fig to use?

1. In an overhead allocation and apportionment exercise you are often presented with factory information. This may include telling you that the labour force all use a canteen. If all are production workers then it is common to split the net cost of the canteen between the various departments on the basis of how many workers are in each department. In a simple example the canteen may cost the company £3,500 per year in subsidies etc. If there are 500 staff in machine shop 1 , 400 in machine shop 2 , 300 in assembly, 500 in packing and 50 in maintenance then there is a total of 1,750 staff who benefit from the canteen. By dividing the £3,500 by 1,750 you can apportion £2 per member of staff to each department i.e. £1,000 to Machine shop 1, £800 to Machine Shop 2 , £600 to assembly , £1,000 to packing and £100 to maintenance. In this way the canteen costs form part of the total overhead in each department. Then each department total overhead is calculated and using a suitable basis an absorption rate is worked out. This absorption rate is the way the overhead cost becomes part of the cost of a product.
3. It also shows in some of the examples that they just add back say 20% of the production overhead to cover the cost of the canteen. Would you do this instead of reapportioning the costs back into production
   20% as a basis for reapportionment may be used as an alternative to the number of staff approach I put forward in (1).
   As a way of finding a unit cost, it is not appropriate in any circumstance that I can think of.
   In some job costing all the overheads may be lumped together and then a % added to the direct cost of a product so that the firm can try to cover their costs, but not on a one overhead at a time approach.
5. Am I right in thinking you won't be expected to work out this % in the exam they will just give you the fig to use? Yes
   In most cases if the overhead analysis question requires reapportionment on a % basis then it will be spelt out. However, they may expect the sort of approach I suggested where we worked out how much subsidy was being given per employee and then multiplied that by the numberof employees in each dept.
   

SandyHood

Igarside
I think you need to keep 2 topics separate

1. Job Costing
2. Overheads analysis

I've written about both to try to answer the questions but the ECR tests them in different questions.
Job costing is a way of working out the cost of products
Overhead analysis is a way of working out a rate (say an overhead absorption rate per labour hour)