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 job position. On the other hand, a cost center hierarchy represents how these cost centers are structured and interconnected.
Companies typically build their cost center hierarchy based on the organizational structure. This hierarchy is crucial not only for analyzing costs by department but also for designing how indirect costs will be allocated to direct cost centers and subsequently, calculate the unit cost for each finished good.
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Defining a cost center hierarchy
Below is an example of a cost center hierarchy for the fictitious plant “Under Controlling Manufacturing Ltd”.
- Level 1: the plant. Creating a level for the entire plant is useful when it is part of a larger group of companies. This allows Corporate Office to differentiate between factories and track their individual results.
- Level 2: department type. The plant is divided into three types of departments:
- Production (PRO).
- Auxiliary Departments to Production (AUX).
- Administrative Departments (ADM).
- Level 3: departments. Production, maintenance, logistics, quality, engineering, finance…
In some cases, companies need to go further in their hierarchy than simply consider the different departments to match their operational complexity, which is common in manufacturing environments. Thus, a fourth level may be required.
- Level 4: Production lines and processes. At this final level, cost centers must be created. The image below shows an example of a four-level standard hierarchy. Some considerations:
- Cost centers within the “PRO-Direct” node correspond to individual production lines in the plant -e.g., PDP01 is the “press 400 tons”. They are called direct cost centers, as they collect expenses than can be directly attributable to each production line, like depreciation or direct labor.
- The rest are indirect cost centers, which collect expenses that cannot be directly allocated to production lines. For example, 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 (e.g.,machine working time, kWh…).
If your company uses SAP, you can create a cost center hierarchy in OKEON.
Node vs. Cost Center
In the hierarchy defined for our company, levels 1 to 3 are not cost centers, but groups of cost centers (also referred to as “nodes”). Cost centers are defined at level 4, and therefore expenses are posted at this level.
Nodes are essential for building the cost center hierarchy and creating a tree structure. Nodes allow you to see the total costs for a specific department (level 3), by department type (level 2) or for the entire plant (level 1).
Codification
It may be useful to define a standard codification for the cost center names to make easier its identification. Moreover, if the plant is part of a large group of companies, this standardization must be defined at the Corporate level and be applied across all the plants.
In our example, cost centers have 5 digit and each of them 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 applicable. |
