Cost driver definition

In order to make rational business decisions, you require viable costing methods to get the correct cost or a figure which is close enough to the actual cost for you to perform reliable cost/revenue analysis. Failure to do so can lead to the closing of a business venture, due to poor cost computation, that may actually be profitable, or at least potentially profitable. Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product. After you get the figures, you would be able to see how your cost per unit has changed with changes in your production strategies. 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.

  • Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities.
  • The cost of each activity is apportioned to specific products or lines of production, based on resources consumed by cost drivers.
  • These overhead costs included salaries of people to purchase, inspect, and store materials.
  • It can also be used in activity-based costing analysis to determine the causes of overhead, which can be used to minimize overhead costs.
  • For example, technology has changed the way pharmaceuticals are manufactured.

A measure such as direct labor-hours or machine hours used to assign overhead costs to products and services is called a cost driver or a(n) _______ _______. 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. While Solo, Band, and Orchestra might appear to be different only in quality, they are actually very different from each other when it comes to manufacturing overhead costs.

Volume Drivers

The document that records the materials, labor, and manufacturing overhead costs charged to a job is the ______. Activities consume resources while customers, products, and channels of production consume activities. Understanding this is fundamental to the cost allocation concept using cost drivers.

The profitability of each customer can also be easily evaluated using cost drivers, and in cases of resource constraints, the less profitable order can be eliminated. Resources should be allocated to the most profitable activities or in proportion to profitability. The cost of each activity is apportioned to specific products or lines of production, based on resources consumed by cost drivers. A cost driver is a factor that creates or drives the cost of the activity. In a system that uses multiple predetermined overhead rates, overhead is applied ______.

Financial and Managerial Accounting

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders. The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity.

Finally, running machines would cost $600,000 for 20,000 machine hours. Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles. Activity-based costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had realized.

Significance of Cost Drivers in Cost Accounting

Advancing technology allows for the now smaller labor force to be more productive than a larger labor force from earlier years. 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. How accurate, then, is the company’s product cost information if it has become more efficient in its production process? Should the company still be using a predetermined overhead application rate based on direct labor hours or machine hours? These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

  • Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.
  • How accurate, then, is the company’s product cost information if it has become more efficient in its production process?
  • All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
  • These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.
  • We are going to look at the following example in order to get a clear picture of how cost drivers are used to derive each product or line of production’s total costs.

This cost driver includes any labor costs related to producing and selling products and services. Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.

COMPANY

In a business venture, the major determinant of whether there will be continuity or discontinuity is cost. If the cost of production exceeds the revenue derived from a sale, there is a great probability of the business closing down. If the costs are less than revenue, there is profit and a probability of expansion. If the costs equal revenue, then the business is at a point of indifference and it can be closed or continued depending on other variables apart from cost or how costs can possibly be adjusted.

What are cost drivers in operations management?

A cost driver is a factor that contributes significantly to the overall expenses of an organization. Identifying and analyzing cost drivers helps companies make sound financial decisions, increase operational efficiency, and allocate resources effectively.

Examples of cost drivers include labor hours, materials used, degree of automation, number of machine setups, number of units produced, number of orders received, and overhead costs. Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, https://accounting-services.net/how-to-figure-out-direct-labor-cost-per-unit/ assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product. The concept is most commonly used to assign overhead costs to the number of produced units. It can also be used in activity-based costing analysis to determine the causes of overhead, which can be used to minimize overhead costs.


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