Cost center accounting is an accounting technique that calculates the costs incurred by a company to create and distribute its products or services. The cost center is an aggregate of indirect costs that refers to a company department, a single production line, or even a commercial office.
It would help if you thought about a concrete example to understand how it works.
Example Of Cost Centers
The story told in the video represents a typical situation found in many companies. A screw company that has the problem of determining the production costs relating to different types of items :
- internally produced screws;
- Screws (in brass) purchased from external subcontractors;
- Both products are sold in industrial packs of 1,000 pieces and smaller boxes of 20 parts intended for DIY and hardware stores.
Therefore the items have different cost structures:
- The production department processes some. Some are not;
- The packaging department processes some. Some are not.
- Therefore, to calculate the cost of the finished product of each item, the various components must be considered. To understand the general logic of cost centers, it is necessary to distinguish between direct and indirect costs.
Direct costs can be measured concerning the single unit of product. In our example, they are:
- the cost of brass screws purchased from external suppliers;
- the raw material for the production of a single screw;
- the wrapper for the 20-piece item;
- the cardboard box of the 1,000-piece package.
In companies organized in this sense, direct costs are managed with a system of bills of materials.
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The Concept Of Relevance
In some cases, the decision to treat a cost as direct depends on the magnitude of that cost. In our example, the cost of the 1,000-piece carton pack probably has such a marginal significance that it can be classified among indirect costs in the more generic item of packaging costs.
This is to streamline administrative work. In practice, the right balance must always be found between the advantage of the information and the complexity of the calculations to be performed. Otherwise, someone would risk getting carried away, even counting the centimeters of tape consumed to close the box.
Indirect costs are all those that cannot be classified as direct costs. This definition is a confusing pun on words, but it’s also the easiest way to identify them. In other words, indirect costs are all those that can not be measured concerning a single unit of product.
In our example, indirect costs are those necessary to operate the production and packaging department, such as personnel, machinery, equipment, and energy.
So far, we have focused on the type of costs that make up the various products, identifying those departments carrying out specific processes for some products. The scheme obtained is called a cost center map. The next phase involves allocating the expenses that refer to each cost center.
In the general ledger, costs are classified by nature without subdivisions between the various departments. Locating costs means breaking down the items in the balance sheet in aggregate form to assign to each cost center a value proportional to the effective use of production factors. Some accounting items, such as personnel or equipment leasing, will be easy to locate.
The Full Company Cost (Total Cost)
When we talk about the cost of a product, it is essential to understand the cost configuration to which we refer. In our example, we have considered the cost of the finished product, which includes the direct and indirect costs of the production and packaging department.
Until now, all costs generated outside these two operating departments have been excluded from our reasoning. It is worth introducing a scheme that draws a broader picture of the company situation to order the ideas.
It should be noted that, about the various cost configurations, the definitions can change from one company to another, just as they differ from book to book. The important thing is that within the same company a common lexicon. The cost center technique can also calculate the company’s total cost. Having a part of the sales managed through sellers and another working directly from the headquarters will be necessary to create a cost center to aggregate all the expenses incurred by the sellers. I refrain from giving other examples. Otherwise, you risk confusing ideas. I want to convey that cost centers can have various ramifications and concern indirect administrative and commercial costs.
Cost centers are used to allocate indirect costs in product costing operations. Each company has its specific characteristics, which depend on the type of business, company size, habits, and so on. In the context of cost center accounting systems, this diversity requires a tailor-made design to identify the best method for allocating indirect costs. The design consists of three phases:
- definition of the cost center map;
- localization of costs;
- allocation (also called turnover) of cost centers on products.