Definition and Meaning

In the business world, a lot of sales transactions happen on credit, i.e. after a specified period of time. In this scenario, there are two main types of discounts allowed to customers. One is trade discount and the other is a cash discount.

Now, after anticipating the amount of cash discount allowable to debtors, a separate “provision for discount on debtors account” is opened and it is very similar to the “provision for doubtful debts account”. The only difference between the two is that provision for a discount is calculated on the debtors’ balance after deducting the provision for doubtful debts.

Journal Entry to Create Provision for Discount on Debtors

1. If a provision for discount on debtors exists at the time of providing the discount, then write off the discount from that provision.
2. A new provision should then be calculated to the extent of bringing the existing provision to the new figure. A journal entry would include debiting P&L account and crediting provision for discount on debtors.
3. If new provision required is lower than the provision already existent, then we need to transfer the difference to P&L account. In this case, the journal entry would be reverse of what is mentioned in the previous point.

Bad debts after trial balance, provision for doubtful debts and provision for discount on debtors will appear on the balance sheet as shown below;

>Read Bad debts and its Journal entries

Meaning and Example

Doubtful debts, as the name suggests, are those receivables which might become bad debts at some point in future. In other words, they are doubtful in recovery.

By analyzing the past trend, a business can ascertain the approximate percentage that becomes uncollectible every year out of the total credit allowed to buyers. This amount, thus estimated, is kept aside from the profits. This provision, made out of profits, is called Provision for Doubtful Debts.

Journal Entry to Create Provision for Doubtful Debts

It is charged against the current year’s profits.

Provision for doubtful debts acts as a liability for the business and is shown on the liability side of a balance sheet. Every year the amount gets changed due to the provision made in the current year. Bad debts for the current year are to be set off, and an additional amount of provision is to be added.

When certain bad debts are to be written off and a provision for doubtful debts is to be made, the amount should be first debited against the existing balance of provision and the remaining balance in the account should be brought up to the required figure.

This can be easily understood as;

The calculation in the case where bad debts occurring in the following year have to be adjusted and an additional amount of provision is to be made, the calculation should be done in the following sequence:

=Bad debts (Add) New provision (Less) Old Provision

>Read Provision for Discount on Debtors

Profit Center

Profit Center is a section of a company that is treated as a separate sub-business within a company to which revenues can be traced. It directly adds to the profits of the company, hence it is responsible for its own costs and revenues.

Each profit centre or a few are managed by profit centre managers who are responsible for their own centers. This helps organizations to compare different profit centers and determine which ones need more attention and are earning fewer profits, etc.

Profit centers may be divisions, subsidiaries or departments. Results of profit centers are generally included in externally reported segment results.

Example

Asset management department (for an asset management company), Sales department, Advice & Wealth Management (for a wealth management company) etc.

Total of AWM will be total of all it sub profit centers

Profit Center and Cost Center

A profit center is that part of the activity of a business that is considered responsible for earning revenue and incurring expenses and also establishes the profit of a particular segment of activity. Profit centers are maintained to measure the performance of each individual to whom the responsibility was delegated.

A cost center is the smallest unit in an operational organization for which distinct cost collection and analysis is attempted. A cost center can be defined as an observable unit in a big organization, that is established for the convenience of cost detection.

Difference in Table Format

Why is the Profit Center important?

Managerial accounting mainly focuses on identifying the sources of profits in a business. This leads to accumulating the revenue generated and the expenses incurred in respect of these sources of profit.

• Most organizations depend on the traditional income statement that shows the overall profit and cost for the whole business. The real problems and opportunities can be explored only with granular information.
• Profit centers can help a business earn a superior return on its investments given the utilization of its limited resources in comparison with alternative opportunities available to it, with help of profit comparison.
• Many businesses try to capture new markets by pricing their products and services too low. Price is very crucial in the absence of value. Charging prices below the required profit renders the business unsustainable. Hence, a grasp on expected profit levels is very much required.
• Profit centers promote healthy competition among different units of the same business. The aim is to allow a microscopic view of the observable units of the business to establish how each of these units is performing financially, in terms of profitability.
• Profit centers increase the profit consciousness of the business leading to overall enhanced profitability of the organization.

Problems with Profit Centers

There are reasons for a business to establish profit centers but, the process may lead to some difficulties also:

• Profit Centers can lead to decentralization. But, decentralized decision making may force the top management to rely further upon the mid-management reports. This leads to a loss of control.
• Divisionalization can lead to additional costs because of the additional required management controls, staff, and record-keeping resources.
• An excess of Profit consciousness may result in overemphasis on short-run profitability at the expense of long-run sustainable growth.
• There is no completely functional system in place yet, to ensure that divisional profit will contribute to the overall organizational growth or not.
• There has to be a check on the level and nature of competition budding among different profit centers of the same business.

Short Quiz for Self-Evaluation

> ReadCost Centerand Service Center

Definition of Cost Center

A function or department in the organization that does not directly add to the profit, but costs the organization money to operate is known as a cost center. The cost center indirectly adds to the profitability of the business.

The cost center operates on a budget decided by the organization. By showcasing operational excellence, the cost centers manage to keep a check on the costs incurred by them and stick to the budgetary restrictions.

The cost centers do not involve themselves in the investment or revenue decisions of an organization. Their main function is to track expenses. This allows for more accurate budgets and forecasts. The data that they provide is basically for internal reporting. The management can use the data provided by cost centers to improve operational efficiency and maximize profits.

Some cost centers observed in organizations are:

• Accounting Department
• IT Department
• HR Department
• Quality Control Department (in case of manufacturing units)
• Maintenance Staff

Example

Human Resources department, Finance department, etc.

Similarly, for the Research & Development department, it incurs lots of costs in its endeavor to come up with new products for the company, though it is difficult to say how much profit it generates for the company. The sum of Research, Planning, and Implementation of new plans will be the total for this department.

Uses

• A cost center is used to track expenditure for a specific function.  Without creating such a cost center, it would take immense effort to measure the cost of supplying this service exactly. It would require breaking up of all expenditures of the business department wise, which is a very tedious task.
• It is also used to allocate resources to the most profitable activities as this requires to track costs for all activities undertaken.

Cost Unit and Cost Center

Cost Unit

It is a representing unit of product, service, or time (can be a combination of these) in respect to which costs may be ascertained, collected, or expressed. For instance, a business may like to determine the cost per tonne of steel, per tonne-kilometre of a transport service, or cost per machine hour.

• A single contract/project can also be a cost unit
• A batch/group of identical items that maintains its identity through one or more stages of production can also be a cost unit
• Cost units are usually units of physical measurement such as area, volume, weight, value, number, or time

Example

A brick-making company ascertains its cost per 1,000 bricks.

An electricity production company measures its cost per kilowatt-hour(kwh).

A hospitality business determines its cost of maintenance per room.

A transport business ascertains its cost incurred per passenger kilometre.

These are the cost units for the above-mentioned businesses and include parameters of physical measurement.

Differences

Sometimes, cost center and cost unit act as one, but they have clear distinguishable characteristics:

Types of Cost Centers

Following is the broad classification of cost centers, observed in an organization:

• Personal CC

A personal cost center refers to a person or a group of people. For example, a sales manager, a workforce manager, etc.

• Impersonal CC

The impersonal cost center refers to a location, equipment, a group of these, or both. For example, the London branch, boiling house, cooling tower, the generator set, etc.

• Production CC

A production cost center is associated with a product or manufacturing work. It is a cost center where the raw material is handled for conversion into finished products. Here both direct and indirect expenses are incurred. For example, machine shops, welding shops, and assembly shops, etc.

• Service CC

A service cost center involves providing services to the production department. It serves as an ancillary unit to a production cost center. For example, payroll processing department, powerhouse, service centers, plant maintenance centers, etc.

Short Quiz for Self-Evaluation

> Read Service Center and Profit Center