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Unit 2: Cost Elements and Classification

firms should try to adjust historical costs to reflect price level changes. If the price of the asset Notes
does not change over time, the historical cost will be the same as the replacement cost. If the
price raises the replacement cost will exceed historical cost and vice versa. During periods of
substantial price variations, historical costs are poor indicators of actual costs.
Profit Centre

A profit centre is a unit of a company that generates revenue in excess of its expenses. It is expected
that, through the sale of goods or services, the unit will turn a profit. This is in contrast to a
cost centre, which is a unit inside a company that generates expenses with no responsibility for
creating revenue. The only expectation a cost centre has is to lower expenses whenever possible
while staying with a specific budget that is determined at the corporate level.

Example: A company may have a variety of distinct departments, divisions, or operating
groups, each with separate responsibilities and each contributing to the overall success of a
company. Cost centres, for example, such as accounting, auditing, or inventory control, have
costs, but do not contribute revenues. As a result, they do not produce profits. A profit centre,
on the other hand, is directly involved in producing revenues, and, if it is managed well, its
revenues exceed its costs and it produces a profit.

Why It Matters

A profit centre must be carefully managed to ensure that the sales generating activities lead to more
revenues than the cost of those activities, thus producing a profit. Creating separate profit centres
within a company allow the management to evaluate the profitability of each unit or business
activity. When assessing a company, it is useful for an investor to classify various components of
a business into cost and profit centres, allowing the investor to evaluate the prospects of various
divisions on a stand-alone or restructured basis and the allocation or elimination of the costs
found in the cost centres.

difference between Cost Centres and Profit Centres

z z Cost centres are the smallest segment of activity or area of responsibility for which costs
are accumulated or ascertained. Where as profit centres are that segment of activity which
is both responsible for Revenue and expenses and disclose profit of a particular segment
of activity.
z z Cost centres are created for accounting convenience, where as profit centres are created to
delegate responsibility to individuals.

z z A cost centres does not have target cost, but efforts are made to minimize cost. But each
profit centre has a profit target.

z z There may be number of cost centres in a profit centre. All profit centres are cost centres but
all cost centres are not profit centres.
Differences between Cost and Profit Centres (Example of IT Firm )

z z In business, an operating unit is either making money or it’s detracting from a company’s
profits. In simple terms, it’s the difference between a profit centre and a cost centre.
z z Conceptually, a business unit is considered a profit centre when “it’s set up as a small
business — it has its own revenue and profit targets,”

z z On the flip side, a company unit such as the human resources department doesn’t earn
revenue or turn a profit. Its objective is to hire, train and support the company’s employees,

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