Cost Driver
Units that significantly impact the cost of a business or a particular activity of the business.
What Is A Cost Driver?
A business will incur various expenses during its operation, classified as costs.
These costs or expenses, depending on the business, are used to acquire raw materials, assets, labor, services, or any other type of goods and services to ensure the uninterrupted operation of the business.
At its core, a cost driver can be defined as something that propels the expenses incurred by a business during its day-to-day operations. From an accounting perspective,
Cost Drivers are units that significantly impact the cost of a business or a particular activity of the business. These drivers range from operating costs like electricity, fuel, and labor costs to asset investments like machinery.
Different businesses and industries will have different drivers that influence cost, and by identifying them, one can manage their business resources more efficiently.
Some of the most common cost drivers for businesses are labor hours, machine hours, material costs, and overhead costs.
Key Takeaways
- Cost Drivers are units that significantly impact the cost of a business or a particular business activity.
- Cost drivers are typically categorized into three primary types: Volume or Activity-Based Drivers, Time-Based Drivers, and Overhead Drivers.
- Different cost driver assumptions are used in different account methods like Standard cost accounting, Activity-based cost accounting, Resource consumption accounting, Throughput accounting, cost volume profit analysis, and economic value added.
- Activity-based accounting, or ABC, is the most widely used accounting method for calculating cost drivers.
- ABC is different from the traditional costing methods as it accounts for multiple drivers of cost and activities involved in the production process and delivery of products and services.
Types Of Cost Drivers
Anything that influences the cost of an activity can be classified as a cost driver. These activities can be classified into groups based on metrics like hours worked, units produced, material used, etc.
Managers can group these drivers of cost according to their preferred account methods, whether it be Standard cost accounting, Activity-based cost accounting, or Resource consumption accounting, based on their managerial and business requirements.
But in general, the following three are the main types of cost drivers that a business can have.
Volume or Activity-Based Drivers
The drivers under this head are influenced by the business's activity level, like the level of production and frequency of sales. The cost will go up and down in accordance with the level of activity.
For instance, in a manufacturing plant, the production level or number of units produced drives cost. If more units are produced, material and labor costs will increase if the workers are paid on the biases of units produced.
In certain cases, increasing production to an optimal level may lead to economies of scale, resulting in reduced average costs. But in general, if the level of activity in the business is high, the cost will also increase and vice versa.
Time-Based Drivers
Time-based drivers are costs that increase with the amount of time spent on a particular activity.
For example, labor hours are a driver of cost that depends on the number of hours worked, so if the worker is being paid by the hour he or she is working, then the cost of labor will increase the longer they work.
Overhead Drivers
Overhead drivers or fixed cost drivers are expenses that remain fixed regardless of the production level or other activities (at the current max capacity excluding direct overhead cost).
Examples of these cost drivers are administration costs, rent, consulting fees, etc. These costs will not change with the production or sales level, increasing or decreasing.
For instance, the salaries of accountants and managers, rent, and consulting fees remain consistent regardless of production or sales fluctuations.
Note
Overheads will change if the organization expands its operation or increases its production or output capacity. It will need to hire more administration staff or rent a new place, which will affect the cost.
There are other drivers of cost like regulatory drivers (tax and legal cost), supply chains or distribution drivers (cost of transportation), etc., depending on the type of business or industry the company is operating.
It is the management's job to identify these drivers of cost so that they can manage the business more efficiently and perform crucial strategies like cost control, pricing strategies, and overall financial planning.
Activity-Based Costing (ABC)
Activity-based costing, or ABC, is one of the most widely used cost driver calculation methods or allocation methods management uses to identify their business expenses.
ABC differs from traditional costing methods, which rely on mostly volume-based allocation methods. ABC accounts for multiple drivers of cost and activities involved in the production process and delivery of products and services.
The ABC process typically involves several key steps:
- Identifying Activities: The first step of ABC is to identify different activities within the business that consume resources.
- These activities can range from manufacturing costs, customer care costs, repair costs, administration costs, or any other area of operation.
- Identifying Drivers of the Cost: After identifying the different activities, the factor or cost driver that is driven or influenced by the different activities needs to be identified.
- These drivers can be the number of setups, direct labor hours, number of orders, number of customer services provided, etc.
- Assigning Costs: The next step is to allocate the costs to the activities based on the consumption of the resources by the said activity. This involves tracking expenses associated with each activity.
- Calculating Activity Rates: Once costs are allocated to activities, the next step is to calculate the activity rate for each driver of cost by dividing the total cost of the activity by the total quantity of the cost driver.
- For example, the cost of machine setups is divided by the number of setups.
- Assigning Costs to Products or Services: After calculating the activity rate, it must be applied to the specific driver of cost associated with each product or service. This assigns overhead costs more accurately, as it considers each cost object's actual consumption of resources.
- Calculating the Total Cost: After determining and allocating the costs, the last step is to sum up all the costs assigned to a particular product or service to find the total cost of the product or service.
Example Of A Cost Allocation Based On Cost Drivers
A company, XYZ, wants to add a new product to its product line and narrows the choice to two products, A and B.
Step 1: Identify Activities That Consume Resources
- Machine Setup: Setting up the production machines has procurement and setup costs that need to be paid to the engineer.
- Material Handling: Moving raw materials to the production area and transporting finished goods to the warehouse cost money and other resources like warehouse space and labor costs.
- Quality Control: Quality control needs to be set up to ensure the quality of products, which will contribute to the total cost of the product.
- General Manufacturing: General manufacturing activities not specific to a particular product, like operating a production machine or repairing and maintaining.
Step 2: Identify Drivers Of Cost
- Machine Setup: The number of machine setups will be the driver of cost for the setting up activity.
- Material Handling: The quantity of raw materials moved and finished goods transported serves as the cost driver for material handling.
- Quality Control: The number of inspections hired will be the cost diver for quality control.
- General Manufacturing: Direct labor hours will be the driver of cost for manufacturing activity.
Step 3: Assign Costs To Activities After Tracking
- Machine Setup costs $150,000 per year
- Material Handling costs $300,000 per year
- Quality Control costs $50,000 per year
- General Manufacturing costs $550,000 per year
Step 4: Calculate Activity Rates
After tracing the costs, it was seen that for $150,000, 100 machines were set up, so the activity rate for machine setup activity will be $150,000 / 1000 = $150 per setup.
Similarly, other activity rates can be calculated;
Material Handling Rate = $300,000 / 10,000 movements = $30 per movement
Quality Control Rate = $50,000 / 200 inspections = $250 per inspection
General Manufacturing Rate = $550,000 / 10,000 direct labor hours = $55 per direct labor hour
Step 5: Assign Costs To Products
To allocate costs to products, let's consider the production requirements for products A and B:
So, product A requires 50 machine setups, 1000 material movements, 15 quality control inspections, and 4000 direct labor hours. The cost rate will come out to be:
Machine Setup Cost = 50 setups * $150/setup = $7,500
Material Handling Cost = 1000 movements * $30/movement = $30,000
Quality Control Cost = 15 inspections * $250/inspection = $3,750
General Manufacturing Cost = 4000 direct labor hours * $55/hour = $220,000
Product B requires 60 machine setups, 1,500 material movements, 20 quality control inspections, and 3500 direct labor hours.
Machine Setup Cost = 60 setups * $150/setup = $9,000
Material Handling Cost = 1500 movements * $30/movement = $45,000
Quality Control Cost = 20 inspections * $250/inspection = $5,000
General Manufacturing Cost = 3500 direct labor hours * $55/hour = $192,500
Step 6: Calculate Total Costs
Finally, sum up the costs assigned to each product to find the total cost for each product:
Total Cost for Product A = $7,500 + $30,000 + $3,750 + $220,000 = $261,250
Total Cost for Product B = $9,000 + $45,000 + $5,000 + $192,500 = $251,500
So, based on ABC, product A will cost $261,250 per unit, and product B will cost $251,500 per unit.
Why Are Cost Drivers Important?
For any business to become profitable, it needs to know which activities use the most resources and how they can be streamlined to make resource consumption more efficient.
Identifying and comprehending cost drivers is pivotal in informed decision-making for managers and accounting professionals.
Following are some of the major points in which finding and calculating cost drivers are important for a business:
- Accurate Cost Allocation: Finding cost drivers in a business operation helps the management allocate the cost more accurately to their product, services, or ongoing projects. This ensures that the costs are borne by appropriate activities based on their resource consumption.
- Improved Cost Control: Knowing which activities consume resources helps the cost accountant and managers track and reduce unnecessary costs that are not generating returns, making cost control more efficient.
- Effective Pricing Strategies: Understanding the actual cost of each product or service enables managers to set competitive prices while maintaining profitability. Accurate pricing strategies are key to staying competitive in the market and maximizing revenue.
- Resource Allocation: Knowing the resource consumption of each activity helps the business allocate resources more efficiently by prioritizing the essential activities and generating the most return for the business.
- Budgeting and Financial Planning: Knowing how many resources an activity needs helps the management plan for the business's finances more accurately. They can plan for short-term financing for their working capital needs more efficiently.
Cost Driver FAQs
Any factor that causes a change in the total cost of producing goods or services can be called a cost driver, for example, materials, labor, overhead, or any other factors that affect the overall cost of production.
The main benefit of cost drivers is that they help organizations understand the total costs associated with producing goods and services, and this information aids the management in making informed decisions about pricing strategies, budgeting, product design, and other areas.
Additionally, tracking drivers of cost can help organizations identify areas for cost reduction and streamline operations.
Cost drivers pinpoint the specific factor that influences the costs within an activity. In contrast, cost pools are accumulations of costs associated with a particular process that are then allocated to specific cost objects.
These drivers of cost are crucial for precise cost allocation to cost objects. In contrast, cost pools help organize and categorize overhead costs for easier allocation to activities before reaching cost objects.
For example, the number of customer orders in a restaurant is a cost driver for kitchen staff wages. The more orders received, the higher the wage costs due to increased kitchen activity.
Kitchen Staff Wages is a cost pool as it accumulates all wage costs associated with the kitchen staff's activities. These costs are then allocated to different menu items using the cost driver, the number of customer orders for each item.
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