An activity cost driver refers to actions that cause variable costs to increase or decrease for a business. Therefore, identifying what product/service is causing particular costs can help the business to become more profitable by better understanding the specific activities that are driving the costs. Cost drivers refer to the factors or activities that significantly influence the cost of producing a product or service.
- They help inform pricing strategies, budgeting decisions, and product design choices.
- Identifying, selecting, and measuring cost drivers is a time-consuming and complicated activity that requires specialized knowledge.
- Resources should be allocated to the most profitable activities or in proportion to profitability.
- Ideally, a cost driver is an activity that is the root cause of why a cost occurs.
Moreover, environmental regulations and market competition significantly impact overall energy costs. Whatever determines the total cost of a particular activity should be analyzed in-depth to ensure that a proper allocation base is used. Cost drivers follow a cause-effect relationship, and if the relationship cannot be established, then a more relevant driver should be looked for. Total production costs are used to set the selling prices for particular products. Thus, if the costs are inaccurate, the profit forecasts will not be accurate, and the whole accounting system of the particular organization will be subject to errors. To understand how cost drivers work, it’s helpful to think about them in terms of cause and effect.
Direct material cost – Types of Cost Drivers
This means that cost drivers don’t just refer to the amount of money spent on a particular item. Instead, they encompass all of the factors that contribute to the overall cost. In simple words, cost drivers are the reason for a cost, and how that cost affects the total amount spent. The number of customers is a significant driver for most companies that provide services to their customers.
- While the labor cost has changed, this decrease may only be temporary as a labor force with higher costs and different skills is often needed.
- When a factory machine requires periodic maintenance, the cost of the maintenance is allocated to the products produced by the machine.
- For example, the direct cost of manufacturing a widget might include the cost of materials, labor, and overhead.
- How accurate, then, is the company’s product cost information if it has become more efficient in its production process?
This driver measures the cost of setting up the manufacturing process for a new batch of products. It allocates indirect expenses like scheduling, preparation, and testing to actual production. This driver measures how many machines are used in the production process. It allocates indirect expenses like depreciation, maintenance, and electricity consumption to actual production. By identifying the key cost drivers within their operations, companies can better manage their spending and optimize their profitability. Therefore, it is critical for businesses to conduct thorough analyses and regularly monitor their cost drivers to remain competitive in their respective markets.
Direct costs are directly traced back to a specific product or service, whereas indirect costs cannot be traced back to a particular product or service. Labor costs refer to the wages and benefits paid to employees contributing to the production process. Businesses must monitor and control labor costs to ensure they are not overspending on salaries, benefits, and other expenses. Cost drivers are essential for promoting competitive advantage and performance.
Cost Drivers Explained – What, Why, and How They Matter
It enables organizations to determine the cost of each activity and the resources used. In ABC, an activity cost driver influences the costs of labor, maintenance, bookkeeper360 review 2023 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.
Cost drivers may vary depending on the situation, making it difficult to produce exact figures. Consequently, managers may make wrong decisions based on inaccurate cost drivers. Measuring cost drivers requires resources such as time, personnel, and technology. These additional costs may not outweigh the benefits of using cost drivers, especially for small businesses. Understanding cost drivers also enables businesses to identify areas of potential risk.
Difficulty in Controlling the Cost Drivers – The Challenges Associated With Cost Drivers
A cost driver is any factor that causes a change in the total cost of producing goods or services. It can include materials, labor, overhead, and other factors that affect the overall cost of production. By identifying and analyzing cost drivers, businesses can gain deeper insights into how much each activity contributes to the overall cost of production. As you can imagine, the unique aspects of the production process for each product affect the overhead cost of each product. However, these costs may not be allocated to the products appropriately when overhead is applied using a predetermined rate based on one activity.
Limited usefulness – The Disadvantages of Cost Drivers
Factors such as productivity, efficiency, and workload influence a company’s labor costs, and any changes to those factors can impact a company’s strategy. A strategy that relies on hiring offshore or technological updates to reduce labor needs may be considered. Cost drivers may differ between industries, properties, or businesses, reducing their comparability. Comparing the costs of two companies using similar cost drivers may be challenging.
For example, in most operations machines are used and, thus, the machine hours used determines the total cost of operating the machine depending on how much money is charged per hour. If a person operates a machine for 10 hours at a cost of $10 per hour, then the total cost that will be charged to the output of that particular time is $100. When deciding which driver to use in terms of allocating indirect cost, consider the cause-and-effect relation between the cost and the driver. In addition, consider whether or not the cost driver activity is easily measurable. The relevant cost refers to the cost’s response to the activity of the driver. In addition, approximate the relationship between costs and cost drivers using regression analysis.
Imagine that McDonald’s needs to clean their ice cream machine after every 200 ice cream cones sold. In this instance, the cost driver would be the number of ice cream cones produced. For this kind of cost driver, it can be raw materials and other items sold in bulk such as food ingredients used in fast-food restaurants, and the price of gas for a gas station. Cost reduction is critical for survival and growth in a highly competitive business environment. Businesses that cannot reduce their cost drivers will struggle to remain profitable and achieve their long-term goals.
Once an organization understands its cost drivers, it can use the knowledge to optimize operations, find opportunities, and differentiate from competitors. Organizations that can effectively manage and control cost drivers can improve overall business performance. Cost drivers provide a way for businesses to measure their performance accurately. By tracking the cost of specific activities over time, companies can evaluate their performance and identify areas where they need to improve. This driver measures the cost of inspecting products to ensure quality standards are met. It allocates indirect expenses like inspection, testing, and analysis to actual production.
Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.
