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Profit Centers vs. Cost Centers
Definition

Profit Center: A unit of an organization that generates both revenue and expenses. Its goal is to have revenue exceed expenses.

Cost Center: A unit of an organization that generates expenses and has no responsibility for generating revenue. Its goal is to adhere to expense budgets.

Why you need to know this: IT professionals should understand how their department and other departments within the company work.

By Thomas Hoffman
(August 02, 1999) 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 center and a cost center.

Conceptually, a business unit is considered a profit center when "it's set up as a small business -- it has its own revenue and profit targets," says Haim Mendelson, the James Irvin Miller professor of information systems and management at the Stanford Business School in Stanford, Calif.

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, and there's a cost to the company to run the unit. As such, human resources is typically viewed as a cost center.

It's important for information technology professionals to understand and differentiate between the two concepts in order to "know how your [IT] organization is viewed by the rest of the company," says Jim Jones, managing director of the Information Management Forum, an Atlanta-based user group for IT executives.

IT departments traditionally were set up as cost centers. An IT organization would charge back costs to a business unit. For example, IT would charge a commercial loan division of a bank for monthly transaction processing costs or mainframe use costs. But it wouldn't bring in a profit because the division would be charged at cost. In some cases, those costs may be absorbed by the company or as part of a business unit's overhead.

If an IT department is a cost center, "the rest of the business views you as a burden," Jones says. The onus is on the group "to prove that you're providing value for the money that's being spent on information technology."

Some CIOs think their IT departments should remain cost centers. "Our core competency [in IT] is to help our company build aircraft structures, not to code [enterprise resource planning] systems, so I could not see us as a profit center," says Julie Peeler, corporate vice president of manufacturing and information systems at The Aerostructures Corp. in Nashville.

So where does the cost center approach work best? "That is like asking a doctor if tetracycline is a good drug. It depends what your illness is," says Eileen Birge, vice president of research at The Concours Group in Houston.

For companies that have a "bloated" IT organization and end users who are "poorly disciplined," a cost center-type approach "isn't going to help you," Birge says.

However, it's common for IT organizations to be set up as cost centers in highly-regulated industries, such as financial services or electric utilities, "to show regulators where the costs are" by charging IT costs to individual business units, Birge says.

Other companies, such as The Hartford Financial Services Group in Hartford, Conn., have elected to set up their IT organizations as profit centers with a goal of generating zero profit.

The idea here is to help the company run more efficiently by making the IT organization compete with external consultants and systems integrators for work from the business units, Birge says.

Because the IT organization is often the biggest cost center in most companies, there's a growing trend to set up IT as a profit center, Birge says. That is especially true in companies where there's a competitive market for IT services.

That means the IT department typically bills other business units for its services. The revenue generated by the IT department should exceed the expenses for delivering the services.

Some organizations believe that approach keeps IT expenses competitive and reduces unnecessary demand for IT services from the business units. It often allows business units to shop for IT services outside the company and, in some cases, permits the IT department to market its services to other companies.

One example of an IT department making money outside the company is at AMR Corp., the parent company of American Airlines, which in 1986 set up its Sabre computing unit as a profit center after seeing how much demand there was for its information services from other airlines, Mendelson says. It was so successful that it spun off into its own company in 1996.

Other companies that have set apart their IT organizations as profit centers include Shell Oil Co. in Houston and United Services Auto Association in San Antonio, Birge says.

Teamwork

Ideally, IT profit centers should be closely aligned with other parts of the company to reach organizational goals. Mendelson points to Charles Schwab & Co. in San Francisco, which set up a separate electronic brokerage division a few years ago. The success of that initiative "has been a joint product of the IT and business people," Mendelson says.

But setting up IT as a profit center has risks. In some organizations, IT managers and staffers are eligible for bonuses if they meet or exceed profit targets. In those instances, the IT organization "has lost some alignment of interests" with the businesses they cater to, Birge says.





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