A cost center is an entity that generates cost within the company. This entity is often a department, but it can also be a business unit, a production line or even a work position. On the other hand, a cost center hierarchy is how those cost centers are structured and interconnected.
Companies usually build their cost center hierarchy based on the organizational structure. This hierarchy is not only important to analyze the costs by department, but also to design how the indirect costs will be allocated among the direct cost centers in order to get the unitary cost per each finished good.
Defining a cost center hiearchy
Below you can find an example of cost center hierarchy for the fictitious plant “Under Controlling Manufacturing Ltd”.
- Level 1: the entire plant. Create a level for the whole plant makes sense when it is part of a group of companies. That way Corporate will be able to differentiate between all the factories and their individual result.
- Level 2: type of department. The plant is split into 3 types of departments:
- Production (PRO).
- Auxiliary departments to the production (AUX).
- Administrative departments (ADM).
- Level 3: departments (production, maintenance, logistics, quality, engineering, finance…).
If your company works in SAP, you can create a cost center hierarchy in OKEON transaction.
Sometimes, plants need to go further in their hierarchy than simply consider the different departments to satisfy their level of complexity (quite common in manufacturing environments). In the following table, a forth level is added for this purpose:
- Level 4: cost centers. It is the most basic entity of cost collection. It is important to remark a couple of points:
- Cost centers within “PRO-Direct” node correspond to each production line of the plant -e.g., PDP01 is the “press 400 tons”. They are called direct cost centers, as they collect expenses than can be directly booked to every production line, like depreciation or direct labor.
- The rest are indirect cost centers, and they collect expenses that cannot be directly allocated to the production lines. One example is the electricity, which can be posted in the cost center PIGEN (Production – variable overheads) and then, distributed among the direct cost centers using a cost driver (machine working time, KWh…).
Node vs. Cost Center
In the hierarchy defined for our company, levels 1 to 3 are not cost centers, but group of cost centers (also called “nodes”). Cost centers are defined at level 4, and therefore expenses are posted at this level.
However nodes are necessary to create the cost center hierarchy and define a tree structure. Nodes allow for knowing the total costs in a certain department (level 3), by type of department (level 2) or for the whole plant (level 1).
It may be useful to define a standard codification for the cost center names to make easier its identification by any member of the company; moreover, if the plant is part of a group of companies, this standardization should be defined at Corporate level and be applied over all the plants.
In our example, cost centers have 5 digit and each one has a meaning:
|Number of digit||1||2||3-5|
|Meaning||Department||Type of activity/labor||Descriptive|
|Options||P – Production|
M – Maintenance
L – Logistics
Q – Quality
E – Engineering
|D – Direct|
I – Indirect
S – Staff (administrative)
|No rules |