This is “Cost Centers Versus Profit Centers”, section 5.8 from the book Managerial Economics Principles (v. 1.0). For details on it (including licensing), click here.
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5.8 Cost Centers Versus Profit Centers
One internal transaction cost in multiple-division companies is how to coordinate the divisions that make internal exchanges so they will achieve what is best for the overall corporation. This challenge is not merely a matter of communication but of providing proper motivation for the individual units.
Large vertically integrated companies often have at least one upstream division that creates a product and a downstream division that distributes it or sells it to consumers. One design for such companies is to have a central upper management that decides what activities and activity levels should be provided by each division. These instructions are given to the division managers. With the output goals of each division established, each division will best contribute to the overall profitability of the corporation by trying to meet its output goals at minimum cost. As such, divisions operating under this philosophy are called cost centers.
Although the cost center design may sound workable in principle, there is some risk in the division having an overall objective of minimizing cost and divisional management evaluated in terms of that objective. The response to this objective is that the firm may cut corners on quality as much as possible and avoid considering innovations that would incur higher initial costs but ultimately result in a better product for the long run. Unless the top-level management is aware of these issues and sets quality requirements properly, opportunities may be missed.
Another problem with cost centers, particularly in the nonprofit and public sectors, is that the compensation and prestige afforded to division managers may be related to the size of division operations. Consequently, the incentive for managers is to try to justify larger cost budgets rather than limit costs.
An alternative to the cost center approach is to treat a division as if it were like a business that had its own revenues and costs. The goal of each division is to create the most value in terms of the difference between its revenues and costs. This is known as a profit center. Division managers of profit centers not only have incentives to avoid waste and improve efficiencies like cost centers but also have an incentive to improve the product in ways that create better value.