COST CENTRES AND OVERHEAD ALLOCATION

A cost centre is a section, product or department of a business that can be held accountable for
some of the costs of the business.
A profit centre is a part of the business for which a separate profit and loss account can be drawn
up. Overhead allocation refers to the way in which a business divides its indirect costs between its
cost centres.
Cost centres, like profit centres, are sections of a business than can be seen as being distinct from
other operations of the firm. In a school, each subject department can be seen as a cost centre. The
Business Studies department has its own salary, stationery and textbook costs. By dividing a large
organisation into cost centres, it is possible to hold individual managers to account for the costs
incurred in their departments.
The total costs of the business can be divided up among each of these cost centres. Similarly, part of
the firms revenues can be seen to be due to the operations of each profit centre. Cost
centres can be the basis for deciding the price to charge for a product. Or even which products to
continue producing, and which to kill off. The idea of using separate centres, instead of just looking
at the firm as a whole, has several purposes:
Accounting management accounting depends on the availability of accurate information to
be able to monitor the activities in all the areas of a business. By using cost centres for separate
products or areas, individual performances can be more easily analysed. This allows firms to take
corrective action wherever necessary.
Organisational the use of cost centres allows managers to see which areas of the business
are working well, and which are underperforming. This helps senior managers make the right
decisions to improve the overall running of the firm.
Motivational theorists argue that giving middle managers control over a distinct area of the
firms operations motivates them more strongly to fulfil their responsibility. They will be
spurred on to make their area the most profitable in the business.
Note that cost centres and profit centres are largely the same thing. The only difference is that cost
centres only incur costs. Profit centres also generate revenues, therefore their profit can be
calculated. For instance the Heinz market research department generates no sales and is therefore a
cost centre. The soups division generates costs and revenues and can therefore be a profit centre.
The way in which a business divides itself up into cost centres will vary according to the
circumstances of the firm. Some of the more common bases for cost centres are:
A product where a firm has several products that can be easily differentiated from each
other, then the different products can each form a cost centre.
A group of machines a particular work area for which the inputs and outputs can be
observed.
A department an area of activity within the business that performs a specific function.

A location if the firm is geographically spread, each separate location can be used as a cost
centre.
A person some individuals may have responsibility for a specific area of operation and
spending, and could be accountable themselves for the costs involved.
If a firm wishes to use cost centres, it will choose a basis that is appropriate for its own situation. A
firm with several factories spread around the country may use location as the basis for its cost
centres. One which produces a range of different products may be more interested in how each of its
products are doing. So it will use the products as individual cost centres.
The aim of using cost centres is to provide managers with information to monitor the performance of
the individual parts of the company. The choice of cost centre must be appropriate to the situation of
the firm.
For the purpose of allocating costs to the various cost centres of the business, it is necessary to
know which costs are direct, and which are indirect.
For example, a car manufacturer will have clear direct costs when it buys components from an
outside firm, such as headlights or tyres. These costs can be attributed directly to the specific make
and model of car being produced. This will provide managers with a precise breakdown of the money
spent on this product.
Alongside the direct costs of producing a car, the firm will also have costs that are not linked
directly to the production of a particular item. These costs are often referred to as overheads. They
cover a range of the firms activities. For example, building a new factory that will produce a
range of different models will be a cost the firm must pay, even though the money paid is not
associated clearly with any one model.
Note that the distinction is not always a clear one -costs such as wages, depreciation and so on can
be either direct or indirect, depending on individual circumstances.
The way a firm allocates its overheads or indirect costs between its products will have a significant
effect on the performance of each of its cost/profit centres.
In a year, a firm produces two products called ABC and XYZ. They produce 100 ABCs and 200 XYZs.
ABCs sell for 5 each, whilst XYZs sell for 8 each. Apart from marketing, it is known that
the total cost of producing ABCs is 200, and of XYZs 800. The total spent on marketing is
600.
The way in which the marketing overhead is allocated between the two products will affect how each
has performed, as shown by the profits made over the year.
From this second example, a manager may conclude that it is worthwhile continuing with the now
profitable ABC product.
Clearly, the method used to allocate costs between different centres will have an effect on how the
performance of each centre looks. It is very important that the method used is fully appreciated by
anyone reviewing the performance of the business and its various cost/profit centres. If not, it could
lead to inappropriate decisions being made with regard to the allocation of resources for future
production.

The most common method of allocating overhead costs are:

full costing
absorption costing
marginal costing.
FULL COSTING
Full costing is the simplest method of allocating indirect overheads between the various cost centres
of a firm. As such, it may also be the least accurate.
When using full costing, an arbitrary method is used to decide what proportion of all the
firms overhead costs are to be allocated to each cost centre. For example, a firm has two
departments, A and B. Department A produces 25% of the firms output by volume, and
department B 75%. If output by volume is the chosen method for allocating all the overheads,
department A will be charged with 25% of all the overhead costs incurred by the business, whilst
department B will account for the remaining 75%.
Relatively simple to use and therefore inexpensive to administer.
All costs are recovered by the costs allocated to each centre.
As will be seen, even the more complex methods of allocating overheads can not guarantee
accuracy, so using such a simple system can be seen as being fair. All departments or areas are
being treated equally.
The arbitrary nature of the allocation method can lead to overheads being unfairly distributed
between the different cost centres. The system might lead to clear absurdities, such as a one-person
department being charged the same for canteen facilities as one with a hundred staff.
Decisions made on the basis of full costing could be incorrect. The information generated by this
system could be misleading.
ABSORPTION COSTING
Absorption costing is a refinement of the full costing method. Instead of using an all-inclusive
approach and allocating total overheads proportionately, each aspect of the overheads is absorbed
separately by cost centres on an appropriate basis.
The way overheads are allocated to each cost centre varies depending on the cost involved.
For example, if we look at the firm mentioned in the full costing section, the overheads of
400,000 might be made up of three elements: 90,000 210,000 100,000
Rent
Canteen costs
Insurance OVERHEAD BASIS FOR ALLOCATION Rent & rates

Physical area taken up by the cost centre Heating

Physical area taken up by the cost centre Canteen costs
Number of employees in the cost centre Health & safety costs
Number of employees in the cost centre Personnel administration
Number of employees in the cost centre Depreciation
Value of capital used by the cost centre Insurance
Value of capital used by the cost centre Using absorption costing, the 75:25 split used earlier is not
appropriate. Instead, we need more information on each department, as below:
Percentage of the physical area used A 66% B 33%
Percentage of total employees 33% 66%
Percentage of total capital used 25% 75%
The overhead costs can now be apportioned to the two cost centres in relation to these different
proportions.
It is fair, as the different rates of usage of each aspect are taken into account.
It ought to give the firm an accurate basis on which to cost each unit of output. This ought to allow
accurate pricing policies, especially if a cost-plus pricing system is used.
Not all costs can be divided accurately in this way -some workers or areas of the factory may be used
by more than one cost centre. This is particularly a problem when a firm makes a wide range of
products.
This approach is more expensive to run than full costing, as it requires careful measurement of
factors like the capital invested into each department.
MARGINAL OR CONTRIBUTION COSTING
Under this approach, the valuation of a centres costs rests solely on the basis of direct costs.
Overheads are excluded from each centres cost total. They are only included when
producing the whole firms profit and loss account.
Financial decisions about a product or a department depend largely upon contribution. Contribution
is the amount of money from the sale of a product that is available for the firm to pay off its fixed
costs. It is found by the calculation: contribution per unit = selling price marginal (direct)
costs
For example, if a product has direct costs of 20 per unit, and is sold for 25, then for each
sale the firm has 5 which it can put towards paying off its overheads, I.e. each sale contributes
5 to fixed costs.

Using this approach, it does not matter how much of the overhead costs each of the firms
products use up. As long as a product can be sold for more than its direct costs, it helps the firm pay
off its fixed costs. Once these have all been paid for, it helps increase the firms profit.
However, while this method allows the firm to make direct comparisons between its different cost or
profit centres, it does nothing to make sure that each is treated fairly. A cost centre that uses a large
proportion of a particular overhead can be seen to be making a positive contribution if this overhead
is ignored. The firm must take care in deciding which costs are direct and which are indirect if this
method is going to be used.
The worked example given above shows that great care must be taken in interpreting the results
obtained from any analysis made on the basis of overhead allocation. There will seldom be a case
where there is a clear distinction between which product each employee works on, or how much
area a cost centre uses. It is extremely unlikely that any system of allocating overheads could ever
be completely fair and unbiased.
Even the use of marginal, or contribution, costing is not as clear cut as it may appear. A positive
contribution is a good sign, but could the resources bring in a better contribution if switched to
boost the output of another product or to develop a completely new one? In other words, what is the
opportunity cost of keeping resources in their present use?
There may, of course, be other reasons for continuing to make a product, even if it does not make a
positive contribution to overheads, such as:
Apparently, Northampton in the UK, has the greatest number of small to medium sized companies
within the uk and website development and printing specialist Tony Powell Graphics (tonyp.co.uk)
have shown that real world printed marketing and advertising such as brochures and leaflets is still
effective in branding a business enterprise.
No matter how wonderful your commercial, personal, or even charitable product or service is, if it
turns out community visibility, you will have limited success.
Start here: All things considered, a winning leaflet or flyer will do numerous tasks: earn the target's
attention, generate curiosity in your company and ask the individual to take an action.
Layout: With reference to structure, its helpful to keep more complex styles to ones online
shop and engage in a more traditional solution for printed material. So many images, colours and
typefaces can dilute your most important branding message. If you'd prefer something bold, go with
a provocative trade mark but keep the remainder of the written content short and snappy. An
individual big image could be more practical in initiating company recognition than numerous
smaller graphics. Find a compelling, striking visual which channels the tone of your subject matter
to be the center of attention.
Length and width: Before thinking about how big or small to make your leaflet or brochure, keep in
mind the delivery procedure. With respect to flyers which might be passed out on a one to one basis,
for instance, A6 paper happens to be convenient as it is small enough for any receiver of the branded
media to put in their shopping bag or wallet. They are often printed on high gloss cardstock.
Pamphlets or brochures which can be delivered via the mail system are likely to be A6 or A5 and
quite often receive the greatest response from potential customers when delivered in enclosed
envelopes. A lot of leaflets, flyers and posters are printed on more lightweight cost efficient paper
weight, with bright glossy finish that makes artwork look very nice and clean.

The tone: Keep your written text constrained and to the point.
Distribution: When knowing the end users on a personal level, it is also possible to go for the perfect
delivery procedure for the printed materials. There are a variety of options to consider: you may
choose to distribute them on their own, with other leaflets, inserted in a magazine or newspaper, on
cars or door-to-door. There are of course, advantages and disadvantages to all of the above methods.
After analysing your target customers needs and habits, the most suitable option will be
clear.
Monitoring impact: Marketing and advertising opportunities or inducements that are leaflet
centered are a fantastic strategy to deliver interaction. A small company won't lose much money and
may benefit if the customers act on it. So long as you are seeking to lower costs and yet reach as
many customers as is possible, leaflets are a great marketing communications approach. If
pamphlets and full colour leaflets are to be an integral part of your marketing or advertising
process, then its also wise to look towards circulation frequently.
Is it part of a product range, which helps to keep total sales up?
Does the product help to symbolise the firm in some way?
Does the product have sentimental value to the owner or to a group of customers?
The use of cost centres and the various methods for allocating overheads needs to be used with care.
It ought not to be taken in isolation from all the other aspects of the firm. Determining the full cost
of a product is difficult. Therefore it is vital to allow for other factors such as the marketing, human
and social implications of a decision.
It is perhaps better to think of the costing methods as ways of finding out which questions to ask,
rather than actually providing answers. If one product has a large share of the physical area of the
business, does it use this space effectively? Are the large numbers of workers in a cost centre
efficient, or would the product, and the firm as a whole, benefit from some capital investment? Only
when such matters are considered can valid judgements about products or other cost centres be
made.
COST CENTRE a department or section of an organisation to which specific costs can be
allocated.
COSTING dividing up production and selling costs into direct and indirect components.
DIRECT COSTS costs that can be attributed directly to a cost centre.
INDIRECT COSTS overheads such as rent which cannot be attributed to a specific cost
centre.

PROFIT CENTRE a department

which generates costs and revenues, allowing
a profit and loss account to be drawn up.