Evaluating Small Business: Is it a Profit Center or Cost Center?

The IRS is generally skeptical about business ventures that span for many years without turning a real, taxable profit. Therefore, it is important when starting or running a business that you are working hard to create a profit, even if the company is private.

The question I asked at the beginning of this article says it all; when an activity is a profit center, it generates wealth. When it is a cost center, it destroys or consumes wealth. Of course, like anything in the world of personal finance, there are some subjective values that must be assigned. And this is totally reasonable. However, it is the act of asking the question—really considering the question and figuring out the answer—that is where the real value comes in.

Not Just For Business Anymore

The problem with many people and their small businesses is that they aren’t profitable. They borrow large sums of money to start up businesses and then tap credit cards, personal loans, additional private funding, and perhaps even the equity in their own home or other assets to continue running businesses that are truly cost centers.

People who operate in this manner end up sabotaging not just their own good money, credit, and overall self-esteem but also the jobs and livelihood of their employees. This is a bad situation, without question. The business, in this scenario is a cost center. It costs more money to run it than it actually generates as income and profit. Usually, this is a significant difference and that monthly or quarterly difference drains the value of other assets or runs up large debts.

Cutting Corners on Cost Centers

Besides high loads of debt, people also often figure out that they want to become ‘the giver’ in a bad situation. So they give away the store to the employees as compensation while taking reduced amounts for themselves.
Sometimes they’ll even get into trouble on their own personal bills. Or, they will try to let months of balances accumulate on their bills before actually paying them out to the people they owe. This might come out of a cheap mentality as well. In fact, some business owners think of it like it is a badge of honor to be cheap; they take pride in trying to run a business venture on a budget that an impoverished child in the third world couldn’t survive on. This cutting of corners on a business venture is a sign that the business is not doing well; indeed, it is likely a cost center.

Profit Centers For Pros

Profit centers are hard to evaluate as well, but the rules are the same. A profit center generates more income than expenses. In the end, there is more money than before the activity started. Ensuring that a business is profitable for a period of time is the goal. It ensures that the owners and employees make money and there is continuity going forward so that there is money that can be invested for the business’ future growth.

Understanding a profit center or a cost center is simple; track the values of income and expenses in the form of a profit and loss statement. This will make it very clear whether or not the activity is a profit or a loss center.

Avoiding IRS Entanglements

One of the most avoidable situations with business problems is filing taxes correctly and maintaining correct documentation. Whether on your home or business taxes, I would encourage you to consult a tax professional if you don’t have the time to review these items on your own. Otherwise, make sure that there is the appropriate documentation for any deductions and figures that are reported as part of your taxes and that you are certain of any interpretations of the tax laws that you are filing your taxes based on. When in doubt, consult a professional.