A profit center is a business unit that generates revenue in excess of costs. Profit centers are expected to turn a profit by selling something. By contrast a cost center in a company provides necessary services but has no revenues. It is expected to keep costs low while providing the assigned services—within the budget. Beyond that simple definition, companies in recent years have attempted to convert service units into profit centers by two basic stratagems: charging for services rendered to internal customers (other departments) and selling a portion of cost-center outputs to outsiders in order to generate revenues. Thus "profit center" has taken on a new meaning as a search for higher profits by putting pressures on functions heretofore shielded from the "market."
All companies, of course, have both cost and profit centers—even the one-person company; in the latter case some things done by the entrepreneur are done to keep things going, others are directly related to revenue generation. In most companies corporate functions such as human resources, information technology (IT), purchasing, maintenance, research, and other staff-functions distant from production are cost centers—not least top management. These are service functions necessary to do other things directly related to the market. Production activities, including engineering, design, data processing tied to the factory, production itself and warehousing and testing associated with it can usually be tied to product and thus are parts of profit centers.
All companies have profit centers and cost centers, but not all companies organize their accounting practices around the "profit center concept." Where this concept has taken root, management makes attempts to view all operations under the rubric of profit and makes attempts to convert functions so that they too have bottom lines.
TRANSFORMING COST INTO A PROFIT CENTER
A cost center may actually provide services that could generate a profit if they were offered on the open market. This theoretical possibility is at the root of profit center accounting. One implementation of the concept is to require departments using a service to pay for it. This, of course, is a meaningless change in bookkeeping (and an added administrative cost) unless the purchasing departments have alternatives to buying from within. Thus implementation typically permits departments to shop around—and buy the service outside the company too. The notion is that such competition will make the "cost center" behave more responsibly in order to "keep the business." Similarly, the newly converted "cost center" is also empowered to sell its services outside. In both cases, selling in or outside, the "cost center" could mark up its costs to get a real profit margin of its own—which, of course, would increase the costs of profit centers.
All cost centers "do something" and therefore theoretically have something to sell—but the marketability of many centers is problematical or, de facto, must be relaunched as new ventures. Thus a human resources department could theoretically turn itself into a recruiting company, but to do so effectively it would have to transform itself, develop its own marketing, and lose its character as an internal service provider concentrating on achieving corporate goals first of all. The "two masters" problem arises. The accounting department's payroll function could also, similarly, head out and do battle for market share with well-entrenched independent payroll services providers.
Certain functions, like information technology, appear more suited to this concept than others because—except for the addition of a selling function—little else (except perhaps expansion) would be required. Managing external databases is functionally the same as managing those in-house. Other technically based functions would have similar advantages, e.g., product design, modeling departments, product testing, etc.
PROS AND CONS
The perceived advantages of "conversion" arise chiefly from the assumption that costs of the function would decline over time and thus make the company more profitable overall. Under competitive pressure, the former cost center would become leaner, more responsive, and more efficient. If successful externally, it would increase total revenues.
The negatives arise from the fact that corporations are "organizations" and therefore both kinds of centers, cost as well as profit, are necessary "organs" of the entity with characteristics that have evolved to make them work ideally together. (Which of our body organs do we wish to change?) The conversion of cost centers into independent functions introduces competitive forces into the organization itself. The motivations of managers running such units change; they begin to be measured by a different yardstick. At a minimum—if this policy is pursued very energetically—it will create tensions and disorders.
Primarily for these reasons, managerial initiatives to implement a profit center culture tend to translate, in practice, into greater focus on the costs and benefits of service elements, tend occasionally to lead to the exploitation of new opportunities for outside sales, but rarely result in creating a chaotic internal "auction" under which operational managers have to expend excessive time and effort to get a part, a data run, or to hire a new employee.
PROFIT CENTERING VS. OUTSOURCING
The attempt to achieve higher returns from internal service functions is conceptually and motivationally similar to moves that result in shedding entire functions—replaced by buying their services from outside vendors. This approach is administratively easier and for that reason, perhaps, growing in extent. (See Outsourcing in this volume.) Transforming an internal department into a service-selling entity, required to find outside customers as well, thus becomes the first stage toward the "Ah hah!" of discovery: namely that the function might not be needed at all. Some departments already buy from the outside. Why not all departments? Let's spin it off!
Companies faced with hide-bound, bureaucratic, resistant, slow-moving, and unresponsive service functions have other alternatives. The most obvious is the radical reorganization of the poorly performing function.
SEE ALSO Outsourcing
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