What Is an Activity Cost Driver?
An activity cost driver is an accounting term. A cost driver affects the cost of specific business activities. 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.
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 in 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 providing services.
An activity cost driver, also known as a causal factor, causes the cost of an activity to increase or decrease. An example is a change in the cost of warehousing or a change in the level of production.
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.
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.
Cost Allocation
When a factory machine 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.
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.
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.
Special Considerations: The Subjectivity of Cost Drivers
Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.
See Also:
Cost Center
Value Drivers: Building Reliable Systems to Sustain
Growth
Direct Labor Variance Formulas
Direct Material Variance Formulas
Step Method Allocation
In accounting, the cost driver definition is a factor that incurs cost. Use cost drivers to allocate variable and indirect costs to production activities or output. Include both indirect costs and direct costs to compute the full cost of production. Because indirect costs, such as variable overhead, are not directly traceable to production activities, allocate them according to a cost driver rate to apply these costs to production activities. Based on the activity of the cost driver, the cost driver rate is the rate indirect costs applied to production activities.
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Choosing Cost Drivers
An indirect or variable cost may have several possible cost drivers. Traditional costing methods allocate indirect costs to production activities based on volume of output. Conversely, activity-based costing allocates indirect costs to particular production activities related to that cost.
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. It is also necessary to consider the cost behavior of the relevant cost. 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.
Use these drivers at differing hierarchical levels. For example, an indirect or variable cost may be relevant at the unit level, the batch level, the product level, the customer level, or the facility level. Once you determine the appropriate hierarchical level, choose a cost driver activity at that level in order to allocate the indirect or variable cost.
Cost Driver Rates
A cost driver rate is the amount of indirect or variable cost assigned to each unit of cost driver activity. For example, you may apply indirect overhead to direct labor hours as $50 dollars per hour. In this case, for each hour of direct labor required for production, the company would then allocate $50 of indirect overhead costs to the production activities or output.
Cost Driver Examples
For illustrative purposes, below are some cost driver examples of indirect or variable costs as well as relevant cost driver bases for these costs.
Cost Cost Driver Maintenance expense Machine hours Fuel costs Miles traveled Electricity expense Hours of factory operation Material handling expense Tons of material handledIf you want to check if your unit economics are sound, then download your free guide here.
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Source:
Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.