Cost Center
A cost center is a defined operational area to which costs are assigned according to the cause-and-effect principle – it answers the question "Where were which costs incurred?". It is the central organizing structure of cost center accounting and makes expenses attributable to individual departments, sites or functions.
A cost center is an organizationally or functionally defined area of a company to which costs are attributed according to the cause-and-effect principle. It answers the question "Where were the costs incurred?" and thus forms the heart of cost center accounting – the second stage of cost and activity accounting, between cost type accounting and cost object accounting. Typical cost centers are individual departments (purchasing, sales, warehouse, accounting), sites, machines or projects. Each is given a unique number to which expenses are co-coded when they are posted.
The benefit lies in transparency: instead of merely knowing that a certain total of personnel, rent or energy costs was incurred (cost type accounting), the cost center shows which area caused these costs. This allows budgets to be managed per department, overhead costs to be allocated appropriately to products, and the profitability of individual areas to be assessed. Cost center accounting is not a legal obligation, but in mid-sized companies it is a standard instrument of internal accounting and can be mapped in virtually every ERP system.
At a glance
- A defined area to which costs are assigned by cause – "Where were costs incurred?"
- Second stage of cost and activity accounting: between cost type and cost object accounting
- Four basic types: primary, auxiliary, pre-cost and general cost centers
- The tool: the cost distribution sheet (BAB) distributes and allocates overhead costs
- Part of internal accounting – voluntary, but mappable in the ERP as a separate dimension alongside the general ledger account
How a cost center works
Cost center accounting picks up where cost type accounting ends. The latter first records which cost types (wages, materials, depreciation, rent) were incurred and in what amounts. Cost center accounting then distributes these costs to the areas in which they arose. Direct costs can be attributed straight away; overhead costs – i.e. costs that cannot be attributed to a single product, such as the rent of a hall – are allocated to the cost centers using appropriate distribution keys (floor space, number of employees, machine hours).
The classic tool for this is the cost distribution sheet (Betriebsabrechnungsbogen, BAB): a matrix in which the cost types correspond to the rows and the cost centers to the columns. Using the BAB, overhead costs are first distributed across all centers (primary cost allocation) and then the services of the auxiliary and pre-cost centers are re-allocated to the main cost centers (secondary cost allocation). In the end, only the main cost centers bear the entire overhead, from which surcharge rates for costing can be derived.
Types of cost centers
Four basic types are distinguished. Main cost centers are directly involved in creating the output (e.g. production, sales) and ultimately pass their costs on to the cost objects. Auxiliary cost centers provide services for other centers (e.g. repair workshop, in-house transport) and are allocated to them. Pre-cost centers (such as energy supply, vehicle fleet) provide preliminary services that are distributed to other centers before final allocation. General cost centers bear costs that serve the entire operation and cannot be directly attributed to any single area, such as building administration or the canteen.
Defining and delimiting cost centers
Cost centers are formed according to criteria that enable a clear and non-overlapping allocation: by function (purchasing, production, administration), by spatial aspects (site, hall), by organizational units (department, team) or by areas of responsibility. It is important that each cost center has a clear person in charge and that the delimitation follows the cause-and-effect principle – only then do the analyses remain meaningful and can responsibility for cost variances be assigned.
Why the cost center matters
Without cost center accounting, cost transparency stops at company level. Only allocation to areas makes management possible: managers receive cost center reports in which the actual and planned costs of their area of responsibility are compared. Variances become visible before they show up in the annual result and can be scrutinized in a targeted way. The cost center thus becomes an instrument of budgeting and responsibility accounting.
At the same time, cost center accounting is the prerequisite for reliable costing. From the overhead costs allocated to the main cost centers, surcharge rates are formed (e.g. material, production or administrative overhead surcharges) with which the cost of goods manufactured for a product or order can be determined. Anyone who does not distribute their overhead costs to areas according to cause is costing blindly and risks permanently subsidizing individual products or customer groups.
Distinction: cost center vs. cost object vs. general ledger account
Three terms are regularly confused, even though they answer different questions. The cost type (mapped via the general ledger account) clarifies which costs were incurred – for example personnel expense or depreciation. The cost center clarifies where the costs arose – in which department or function. The cost object clarifies what the costs were incurred for – for which product, order or service.
These three dimensions build on one another: cost type accounting, cost center accounting and cost object accounting together form cost and activity accounting. One and the same expense – for example the wage of an installer – is recorded via its general ledger account as a cost type, assigned to its cost center "Assembly" and finally charged proportionally to the cost object, i.e. the specific customer order. Only the interplay of all three levels produces a complete picture of the cost structure.
The cost center in the ERP system
In an ERP or merchandise management system, the cost center is stored as a separate coding dimension alongside the general ledger account. With every posting – whether an incoming invoice, payroll run or depreciation – a cost center can be added in addition to the account. Many systems automate this via rules: a specific supplier invoice or item type is assigned to a cost center by default, so the coding does not have to be done manually for every document.
The advantage of ERP integration lies in the analysis. Because operational processes and accounting converge in one system, cost center reports, target/actual comparisons and BAB analyses can be produced without a separate secondary calculation. When exporting to the tax advisor – for example in DATEV format – the cost center is passed on as an additional field, so that cost accounting remains consistent end to end. How deep cost center accounting reaches differs from system to system: some offer only a simple assignment, others full cost center and cost object accounting with allocations and distribution keys.
DACH specifics
Cost center accounting is part of internal accounting and is therefore not legally required – unlike financial accounting with its balance sheet and profit and loss statement. In practice, it is nevertheless widespread in the German-speaking region because it is closely linked to the established methodology of cost and activity accounting (KLR), which is firmly anchored in commercial training and the controlling standard.
An exception is public administration and parts of the healthcare sector: there, cost and activity accounting with cost centers is partly mandatory due to regulations such as municipal double-entry bookkeeping (Doppik) or – for hospitals – the costing in the DRG system. For private-sector companies, cost center accounting remains voluntary, but in practice it is the basis of any serious contribution margin and profitability analysis.
Example
Example: online retailer introduces cost centers for three areas
A mid-sized online retailer with around 40 employees wants to know why the margin is falling despite rising revenue. Until now, all costs have landed undifferentiated in accounting. In the ERP system, the company sets up three main cost centers: "Warehouse & Shipping", "Customer Service" and "Marketing". When coding incoming invoices and the payroll run, the appropriate cost center is now always posted in addition to the general ledger account – packaging material and shipping costs to "Warehouse & Shipping", Google Ads invoices to "Marketing".
After one quarter, the cost center report shows that the costs of the "Warehouse & Shipping" cost center have grown disproportionately because the return rate has risen. The area manager can now take targeted countermeasures instead of searching for the cause in the overall result. Without the cost centers, the connection between returns and the erosion of margin would have remained invisible in the accounting thicket.
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