There appear to be two ongoing schools of thought when it comes to business management structures and organizations. There are probably many more than that but for purposes of the time and space that I have here, I am going to impose the writer’s “power of the pen” and focus on the two that have already alluded to, namely cost centers and profitability (and loss). For the most part just about every other organizational structure is a variant or hybrid of these. You will also occasionally see them referred to as “Matrix” management models and “General” management models.

There are competing schools of business thought when it comes to costs centers. On one side it is felt that it is easier and more efficient to manage your costs when you group them into one specific organization. The idea here is that if you get your costs into one location that there will be several obvious efficiencies and economies of scale that can be taken advantage of to either reduce costs or at the very least slow their growth. As we all know, reducing costs will help improve profitability and creating cost centers is a very seductive argument for reducing costs.

A potential disadvantage to this model is that costs end up being the responsibility of a group other than the business group responsible for revenue or profitability. Because the costs are assigned from a shared pool, the cost center, they may or may not be directly linked to the revenue or business activities that the associated costs are supporting. Here costs are in effect “assigned” to rather than directly associated with the revenue they are responsible for generating.

The other school of thought when it comes to cost centers is that costs should directly be associated with the revenue that they drive. This is the general management model. The idea here is that the revenue, profitability and the costs for a specific business unit should all reside in that specific business unit. In doing this you enable the business unit leader to manage and “fix” his costs in direct proportion to and in association with his revenue in order to achieve his profit objectives.

A potential disadvantage with this model is that some businesses may be too small or may not be far enough along the efficiency curve to endure the incremental costs they require and hence suffer reduced profitability. Because costs are not shared each business unit may in effect be less efficient than they would be if their costs were shared.

So with the lines being drawn and the costs piling up, what do you do? Which structure to implement for the best profitability of the business?

Businesses (and business analysts for that matter) like predictability. They like to know in very specific financial terms what they can expect from their businesses. While the Cost Center and the Profitability models both offer certain aspects of predictability it seems that the profitability model offers the best financial predictability. It is only in this model that all specific and applicable costs are known, defined and fixed within the confines of the business. In the Cost Center model costs are allocated according to some predefined algorithm. While the method or algorithm may be fixed, the actual value of the costs that are assigned can vary. Adding another variable into a business’s cost structure increases the unpredictability of its performance.

As an example, assume there is a cost center that allocates its costs based on support requests. If there are three businesses sharing the cost center and one of the three experiences an unexpected increase in its support requests on the cost center, its costs will rise during that period while the other two businesses costs through no action of their own will go down. Conversely if one of the businesses experiences a reduction in support requests its costs will go down while the other two businesses through no action of their own will go up. In this way cost centers can turn fixed costs into variable costs.

Lastly when dealing with cost centers there comes the issue of governance and leadership. In business for the most part we are looking to grow. We want to grow our business, and with it, our responsibilities. When it comes to cost centers we must always ask the cost center leadership to take the contrary approach and reduce the cost center or at the very least limit its growth. In my experience this has seldom been the case with cost centers. If the supported businesses do not have direct control over the cost center growth and costs, they invariably grow at a faster rate than the supported businesses grow.

In the profitability / General Management model all costs directly associated with a particular business are attached to that business. The market doesn’t dictate what costs the business can or will bear. The market dictates what price the business can expect for its good or service. It is then the profitability objectives of the business that dictate what costs the business can bear in the pursuit of the market price. By putting the cost and price controls in the hands of the business owner, instead of separating them into the hands of the cost center owner and the business owner, you will far more regularly get a more efficient and lower cost solution.

There may be questions regarding lost efficiencies, or biases against smaller businesses in this profitability model. These types of businesses may in fact be able to be served by a cost center model, but should be only in a cost center model where fixed amounts of costs are purchased from the cost center by the business. The idea here is that the business must always decide on the amount of cost that it wants or can afford, hence the cost purchase approach to cost centers.

As I noted before, businesses like predictability, and there is nothing more predictable than a fixed cost. It may be good or bad, but it is known. And known costs can be planned for and dealt with. When direct costs are associated with and controlled by the business, they can and will become fixed. When multiple business’s costs are lumped together into a “Cost Center” there will always be a question regarding the efficiency and value received by the business for the amount of cost allocated to each business. There will be the incremental cost of the cost center management that must also be allocated and paid for. There will also be less control over the content and growth of those costs in the cost center, unless a budgeted cost arrangement can be put in place between the served businesses and the serving cost center.

As I also noted, the arguments in support of cost centers are seductive, but in the reality of their implementation they present multiple issues to the efficient operation of a business. Every effort should be made to find a way to directly attach and fix the costs and decisions about the costs to the revenue and the business that is recognizing the revenue for the most efficient and lowest cost business operation.