Cost Driver Know the Significance of Cost Drivers in Cost Accounting

A cost object is any element of a business for which a separate measurement of cost is undertaken, such as a product, service, department or project. Cost objects enhance transparency in the allocation, reporting and control of costs in an organization. It is a complex process, and not every business can apply the cost drivers in its activities.

For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000. The company would have 4,000 inspections and overhead of $400,000. Finally, running machines would cost $600,000 for 20,000 machine hours.

How Activity Cost Drivers Work

Cost drivers are just a term for the various factors that contribute to the total cost. Fixed costs, such as postage, web hosting fees, business licenses, and banking fees, are often overlooked as cost drivers. This cost driver includes any labor costs related to producing and selling products and services.

Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing , and packing in containers. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste.

How to choose non-financial cost drivers?

Cost AccountingCost accounting is a defined stream of managerial accounting used for ascertaining the overall cost of production. It measures, records and analyzes both fixed and variable costs for this purpose. Cost drivers are used to determine the cost of producing a good or service and are used to allocate costs among different organizational units.

Salesperson head count is often the driver for auto and other employee travel expense. It improves the relationship between the departments, as there are many common activities and processes which are performed for in various department. Caroline Banton has 6+ years of experience as a freelance writer of business and finance articles. Our writing and editorial staff are a team of experts holding advanced what is a cost driver in accounting financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year.

Chapter 4: Activity-Based Costing

For example, equipment depreciation goes to the end product in a production activity. In some cases, the end product may not be a finished good but simply an intermediary good that moves to the next activity. Either way, the charge-based activity cost driver applies the costs all at one time. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.

Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher. Manufacturers that want to know the true costs of their products need to know what is driving their indirect manufacturing costs. For these companies it is not sufficient to merely spread overhead costs to products by using a single factor such as direct labor hours or production machine hours. The concept is most commonly used to assign overhead costs to the number of produced units.

Doing this helps to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy and churn out higher profits. Activity cost drivers include direct labor hours, the cost of warehousing, order frequency, and product returns. As a result, cost drivers are most relevant in the ABC costing system.

For example, set up transactional drivers for such activities as processing purchase orders, receiving products, or scheduling production runs. An example of an activity cost driver in a manufacturing plant is the number of orders that must be produced. Everyday thousands of cars are ordered into the production line by management.

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Common ABC systems use broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity, unit-level activity, organization-level activity, and product-level activity. Different organizations use different categories and terminology, but the basic concepts are the same.

• This cost driver includes any labor costs related to producing and selling products and services.
• A cost driver rate is the amount of indirect or variable cost assigned to each unit of cost driver activity.
• Drive the activity cost to the cost object or another activity and distribute the activity costs to cost objects such as products, customers, and channels.
• These levels include batch-level activity, unit-level activity, organization-level activity, and product-level activity.

The cost of operating and maintaining the equipment falls into the same bucket as production, when automated. When determining the cost drivers in a business, set them into distinct categories based on the activity. One common activity-based cost driver is purchasing materials. Production is impossible without the raw materials and this is an activity that will always factor into the overhead structure.