Criteria For Choosing Cost Drivers
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- Criteria For Choosing Cost Drivers
- Three Criteria For Evaluating Cost Functions And Choosing Cost Drivers
What Is an Activity Cost Driver?
An activity cost driver is an accounting term. A cost driver affects the expenses of certain business operations. In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.
How Activity Cost Drivers Work
Criteria For Choosing Cost Drivers
A cost driver directly influences a business activity. There may be multiple cost drivers associated with an activity. For example, direct labor hours are a driver of most activities or product manufacturing. If the cost of labor is high, this will increase the cost of producing all company products or services. If the cost of warehousing is high, this will also increase the expenses incurred for product manufacturing or service provision.
[Important: An activity cost driver, also known as a causal factor, causes the cost of an activity to increase or decrease; such a factor or driver could be a change in the cost of warehousing or a change in the level of production.]
Other, more technical cost drivers are machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.
Cost Allocation
In a situation where a factory has a machine that requires periodic maintenance, the cost of the maintenance is allocated to the products produced by the machine. For example, the cost driver selected is 'machinery hours.' After every 1,000 machine hours, there is a maintenance expense of $500. Therefore, every machine hour results in a 50 cent (500 / 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine hours.
Three Criteria For Evaluating Cost Functions And Choosing Cost Drivers
Distribution of Overhead Costs
A cost driver simplifies the allocation of manufacturing overhead. The correct allocation of manufacturing overhead is important to determine the true cost of a product. Internal management uses the cost of a product to determine the prices of the products they produce. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity.
Key Takeaways
- Activity-based costing (ABC) is an accounting method that allocates both direct and indirect costs to business activities.
- A cost driver simplifies the allocation of manufacturing overheads, such as the costs of factory space and electricity.
- Management selects cost drivers based on the associated variables of the expense incurred.
Special Considerations: The Subjectivity of Cost Drivers
Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards or regulations stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.
[Fast Fact: Activity-based costing (ABC) is a more accurate way of allocating both direct and indirect costs; ABC calculates the true cost of each product by identifying the amount of resources consumed by a business activity, such as electricity or man hours.]
A cost driver is the unit of an activity that causes the change in activity's cost.
cost driver is any factor which causes a change in the cost of an activity
'Cost drivers are the structural determinants of the cost of an activity, reflecting any linkages or interrelationships that affect it'.[1] Therefore we could assume that the cost drivers determine the cost behavior within the activities, reflecting the links that these have with other activities and relationships that affect them.
The Activity Based Costing (ABC) approach relates indirect cost to the activities that drive them to be incurred. Activity Based Costing is based on the belief that activities cause costs and therefore a link should be established between activities and product. The cost drivers thus are the link between the activities and the cost.
Generally, the cost driver for short term indirect variable costs may be the volume of output/activity; but for long term indirect variable costs, the cost drivers will not be related to volume of output/activity.
In traditional costing the cost driver to allocate indirect cost to cost objects was volume of output. With the change in business structures, technology and thereby cost structures it was found that the volume of output was not the only cost driver. John Shank and Vijay Govindarajan list cost drivers into two categories:[2]Structural cost drivers that are derived from the business strategic choices about its underlying economic structure such as scale and scope of operations, complexity of products, use of technology, etc., andExecutional cost drivers that are derived from the execution of the business activities such as capacity utilization, plant layout, work-force involvement, etc.Resource cost Driver is measure of quantity of resources consumed by an activity. It is used to assign cost of a resource to activity or cost pool.Activity Cost Driver is measure of frequency and intensity of demand placed on activities by cost object. It is used to assign activity costs to cost objects.
To carry out a value chain analysis, ABC is a necessary tool. To carry out ABC, it is necessary that cost drivers are established for different cost pools.
Examples[edit]
Some examples of indirect costs and their drivers are: indirect costs for maintenance, with the possible driver of this cost being the number of machine hours; or, the indirect cost of handling raw-material cost, which may be driven by the number of orders received; or, inspection costs that are driven by the number of inspections or the hours of inspection or production runs. In marketing, cost drivers are Number of advertisements, Number of sales personnel etc. In Customer service, cost drivers are Number of service calls attended, number of staff in service department, number of warranties handled, Hours spent on servicing etc. Garmin g1000 pc trainer for cessna nav iii download.
References[edit]
- ^'Competitive Advantage', by Michael Porter
- ^Strategic Cost Management: The New Tool for Competitive Advantage by Shank and Govindarajan
- “Cost Accounting: a managerial emphasis”, 12th Edition (2005) by Charles T. Horngren, George Foster and Srikant Datar