Cost Centers vs. Profit Centers

Cost Centers vs. Profit Centers

By Diane M. Calabrese / Published March 2020

Bathroom tissue goes into a cost center: supplies for facility maintenance. Easy enough. Sorting business activities and items into cost and profit categories is simple. Or is it?

Although it’s difficult to think of a situation in which toilet paper would contribute to profit, other activities and items are not so easily assigned. Consider human resources (HR). Hiring, payroll, and tracking and administering benefits are all costs. So human resources are a cost center, correct? Not in the broad thinking of the 21st century, which maintains that just about any cost center in business can add to profits.

For HR, the addition is most likely to come through shoring up processes, reducing the cost of routine activities year-after-year. It’s a reminder that all business planning aims at one thing: Minimize the costs associated with generating each dollar realized by selling products or services.

Contractors, distributors, and manufacturers have some common cost centers. Among them are the cost of employees, marketing, technology (including cybersecurity), utilities, vehicles, licenses, insurance, and taxes. Just that short list is enough to cause any business owner to pause and wonder how profit ever follows.

To be sure, in January 2020 the strong double-digit nets are being recorded in banking and financial sectors (some topping 30 percent), while some sectors (e.g., green and renewable energy) are in negative territory. For most companies, net profit—after all the costs of generating revenue are subtracted—falls well below 10 percent of gross revenue.

Many contractors in our industry work as owner-operators with no employees, thereby reducing some costs. The addition of a single employee to a business increases costs because of mandatory requirements, such as payment of workers’ compensation premiums. Insurers of vehicles also charge for additional drivers. Employees are a cost center at all businesses, but for a young contractor aiming to grow, they can be a big one.

There are ways that contractors can keep more of every dollar in sales. They can upgrade equipment to the fastest and most reliable machines they can afford, which leads to greater speed and efficiency at job sites. They can also charge appropriately for jobs. The calculation that breaking even or taking a loss might lead to more work is a perennially bad idea. If no profitable work follows from the customer, the loss is just a loss; and worse, the customer’s expectations for worth of the work done—expectations that may spread to potential customers—are set low.

Selling more and selling a greater array of products, as well as adding a service center, are ways that distributors can add to profit. But the storage and inventory considerations with more products, or the equipment and space needs of a service center, add to costs.

Distributors also add to profit centers by selling higher quality equipment, which commands a premium price, and by selling expertise. Customization is another method distributors use to add to profit.

Throughput is a term most often associated with manufacturing, and manufacturers do add to profit by increasing the efficiency with which their products are made and transported to customers. Yet all parts of industry can realize gains from faster throughput. The more quickly a contractor completes a job and the more quickly the distributor completes a sale are both dimensions of enhanced throughput.

Members of our industry are like those of any industry. They enjoy a collegial environment in which they can discuss trends, regulations, and experiences. They are unlikely, though, to reveal net profit for a year even to a close colleague.

Many members of our industry are willing, however, to strengthen their businesses by contributing financial data to a third party for analysis in return for a snapshot of how they are performing in the context of competitors. The Cleaning Equipment Trade Association (CETA) offers manufacturers and distributors the opportunity to participate in such a program. (There are many other programs, including possibilities for contractors.)

Results obtained by committing to third-party analysis can be used to take a critical look at the cost of profit. For example, if a competitor is generating twice as much in sales per sales representative, it may signal the need for fewer sales representatives, fewer hours spent on each sale, or a different coverage of territory (i.e. less travel, more time with customers).

Getting Started

Sometimes it’s more painless to consider how to minimize dollars going to cost centers and maximize dollars going to profit centers via an oblique approach. Instead of facing cost allocation in our industry, let’s try another industry and adapt what we can.

Virginia Cooperative Extension offers a document titled “The ABCs of Cost Allocation in the Wood Products Industry: Applications in the Furniture Industry” (www.pubs.ext.vt.edu/420/420-147/420-147.html) by Henry Quesada-Pineda, for free use and dissemination. We highlight some of its content in the next three paragraphs.

Design, according to Quesada-Pineda’s work, is often overlooked as a cost center in wood products (e.g., furniture). By not giving enough attention to design and engineering of products, a manufacturer may incur costs downstream. A product that brings customer complaints not only will lose market share but will also require time to address complaints. Investment in design and engineering may be costly on the surface, but if it allows for a smooth rollout of a product that is quickly embraced, it will boost a profit center.

Then there’s process. A cost is tied to every process. In the Quesada-Pineda example, it was lumber moving from yard to kiln. That transport was too costly. What about in a pressure washer manufacturing line? How directly do parts move to the places they are needed for assembly, and so on? Any stretch of process that can be shortened—in distance and time—reduces a cost center. (Many manufacturers in our industry have committed to Lean manufacturing principles to ferret out just such costs and reduce them.)

Improvement in realizing profit only comes when fully considering all drivers of costs. Quesada-Pineda cites the importance of incorporating all costs. In most basic terms, a segment of the manufacturing line may be completely automated and reduce labor costs, but there is still a cost associated with maintaining (e.g., maintaining and upgrading) the automation. It has to be put into a cost center. When a manufacturer understands every cost center, it’s possible to add value to every product by taking each feasible opportunity to reduce the cost of producing it.

Adding value to each product, pressure washer sale, or contract-cleaning job is the easiest way to realize more profit. The cost of producing the product (or sale or service completed) must include materials used, labor, and overhead (i.e., all the ancillaries from insurance to utilities). Then, it’s possible to look at the actual profit.

For those just getting started on taking a clear-eyed view of cost centers vs. profit centers, there’s plenty of free help available. The U.S. Small Business Administration has an excellent primer on cost-benefit analysis (CBA), which is available at www.sba.gov/business-guide/manage-your-business/manage-your-finances.

CBA is one method of accounting for and looking critically at the return on new ventures. If the cost of the initiative will be more than the return, going ahead is not wise—except when it is. We all know examples of ventures that were financial losers to start and then became big profit makers. The problem is that companies with limited reserves or those that do not want to risk all their reserves cannot move forward on such ventures without great risk.

There’s no single method for outlining costs. In general, though, contractors, distributors, and manufacturers will all have cost centers for space (rent/mortgage, insurance, utilities), employees (payroll, taxes, benefits), professional services (accounting, legal, other), supplies (operating, office), marketing, and miscellaneous (liability insurance, repairs and maintenance, professional dues). In addition, manufacturers will have cost centers for raw materials and transportation. Distributors will have a cost center for shipping.

Realism. Large buyers of products and services look for it when evaluating a response to an invitation to bid. They become suspicious of low bids and lightning-quick schedules. It’s because they are looking for a level-headed partner, one who knows the reality of cost centers and profit centers.

By taking a candid look at cost and profit centers and reviewing them at regular intervals, a business is better able to provide realistic responses to potential customers seeking to purchase goods or services. That’s one of the most important reasons—second only to getting the most profit from every dollar of revenue—to have firm knowledge of the centers. 

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