Understanding your business is essential and one of the best methods in doing so is the analysis of cost and profit centres.
There are dozens of methods an analyst can use to understand the internal workings of a business with the goal of improving efficiency and, ultimately, profit.
One of these methods is examining an organisation in terms of cost and profit centres. Almost every business has cost centres and profit centres. Ideally, every aspect of your organisation would be independently profitable. In reality, it simply isn’t feasible.
Often, business leaders create cost and profit centres as a means of isolating expenses in order to focus on profit-generating operations. This delineation can have a positive impact on the business’ performance.
What are Profit Centres?
A profit centre is a particular department within an organisation that is focused on generating revenue. Basically, it brings in more money than it costs to operate.
Conversely, a cost centre is a business unit that does not make more money than it costs to operate. Costs are expected, controlled and accounted for.
Profit centres are focused on increasing the amount of revenue they generate. Like cost centres, they might have a specifically allocated budget that they must maintain, but in many cases, their expenses are allowed to increase in scale with profits.
How to Create Profit Centres
For most businesses, the existence of cost centres is a given. However, with innovative thought and new methods, cost centres can be transformed into profit centres. A common example of this reversal is information technology. IT is usually an expense. However, with a strong focus on efficiency and accurate calculation of ROI, many IT departments can impart a higher dollar value in benefits to an organisation than they cost to operate.
The three most basic methods of transforming cost centres into profit centres are:
• Re-evaluating and reducing overhead
• Creating new revenue sources
• Realigning the department’s efforts with overall business goals
Additionally, business restructuring can also create new profit centres; however this often comes with added cost centres.
The most common method of restructuring a business to create new profit centres involves focusing on product lines in a vertical fashion, rather than functional lines or geographic regions.
For example, rather than having a single research department that focuses on product innovation for a company’s entire offering, it may be advisable to have individual product departments that focus on product innovation for their own product. Restructuring in this manner takes advantage of the tacit knowledge involved in certain product offerings and can greatly reduce time and cost wastage.
One of the great advantages to moving away from a geographically-focused structure to a product-focused structure is the ability to centralise major aspects of production. For example, rather than developing specific aspects of a product in multiple regions to service that region alone, the process could be centralised. All development or production aspects would occur in one location at a greatly reduced price. General motors is an excellent example of this method, with large, centralised manufacturing facilities, producing and distributing vehicles for use in multiple markets around the world.
The Benefits of Profit Centres
There are many obvious benefits to profit centres. By focusing your revenue-generating efforts into specific business units, you can ensure higher levels of productivity. Additionally, you can ease the burden on other business departments by having clearly delineated cost and profit centres. Cost centre performance might increase when a manager’s focus is directed towards limiting overhead, rather than increasing revenue.
The Costs of Profit Centres
Without a clearly structured strategy that aligns with overall business goals, profit centres may fail to reduce their existing costs. Worse, overriding emphasis on revenue generation can reduce risk-taking and innovation, with managers instead opting to pursue safe sources of revenue rather than those that may provide higher returns over the long term.
By creating specific cost and profit centres, the incentive to maintain efficiency can be removed from cost centres. Without a system in place to encourage upward trends of productivity and savings, some cost centres become complacent and simply seek to maintain their expenditures within their allocated budget.
Plan, then Act
Delineating your business into cost and profit centres can provide impressive returns. However, it is imperative that all business units are concentrated on overall organisational goals, with plans and incentives in place to achieve them.