Cost Driver in Accounting: Analysis & Examples What is a Cost Driver? Video & Lesson Transcript

Cost drivers are important because they allow management to better understand the true costs by improving overhead allocation to their products. 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.

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. In other words, direct costs drive the cost of a product, whereas indirect costs drive the cost of the entire organization. For example, direct prices include parts, labor, and materials if a company manufactures a car.

Use activity-based costing (ABC) – How Can a Company Track and Report 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. Activity-based costing (ABC) is a more accurate way of allocating both direct and indirect costs. ABC calculates the true cost https://personal-accounting.org/activity-cost-driver-definition/ of each product by identifying the amount of resources consumed by a business activity, such as electricity or man hours. 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.

• Organizations can adequately analyze their operations by identifying cost drivers and areas where processes can be improved.
• Activity Based Costing is based on the belief that activities cause costs and therefore a link should be established between activities and product.
• A well-identified cost driver enables the organization to accurately calculate the actual cost of a product or service.
• Understanding this is fundamental to the cost allocation concept using cost drivers.
• Consequently, managers may make wrong decisions based on inaccurate cost drivers.
• These additional costs may not outweigh the benefits of using cost drivers, especially for small businesses.

For instance, reducing one cost driver may increase another, resulting in a net effect of zero. This makes cost management challenging as organizations must balance different cost drivers simultaneously. 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.

What are Examples of Cost Drivers?

You measure the number of items produced or delivered and then divide it by total cost. This method allows you to identify the current costs per unit for various products, services, and customers (if differentiated). When a factory machine requires periodic maintenance, the cost of the maintenance is allocated to the products produced by the machine.

• The cost drivers thus are the link between the activities and the cost of the product.
• The relevant cost refers to the cost’s response to the activity of the driver.
• Adopting technology can help businesses optimize their operations and reduce the impact of cost drivers.
• A basic example of cost-driving is linking total sales traffic with the number of staff working outside the store.
• Manufacturers that want to know the true costs of their products need to know what is driving their indirect manufacturing costs.
• Total production costs are used to set the selling prices for particular products.

However, companies must weigh the cost of upgrading or purchasing technology and equipment against the anticipated benefits they could bring to the company. A comprehensive plan and analysis of the business needs and investment requirements can help build an effective strategy. Measuring cost drivers may be challenging if a company does not have sophisticated systems and procedures in place. Implementing cost drivers may require significant technological, training, and infrastructure investments.

Join PRO or PRO Plus and Get Lifetime Access to Our Premium Materials

Before we apply these allocation rates to the activity bases, check your understanding of the process of setting rates. Cost drivers and activity-based costing (ABC) are two concepts closely related in business. Ratio analysis uses financial ratios to evaluate a company’s financial performance.

• Stay the same regardless of how many units you produce or sell, as long as your company keeps operating at 100%.
• By identifying which activities are critical to production and which are not, companies can optimize their operations to minimize waste and improve efficiency.
• Cost drivers are defined as a unit of activity that causes a business to endure costs.
• This driver measures the amount of time spent by employees in the production of goods or services.
• Cost driver can be any measurable input that affects the costs of a company, either directly or indirectly.

It helps to identify the underlying factors driving the overall cost of a product or service. By breaking down the cost structure, businesses can pinpoint the specific areas that require improvement to reduce overall costs. Understanding the impact of cost drivers on your business can help you develop an effective business strategy that increases profits and reduces expenses. In this regard, here is a breakdown of what factors into costs and some business tactics. Manufacturers rely heavily on various cost drivers to manage the costs of producing their goods.

What Tools Can You Use to Help You Identify and Control the Cost Drivers?

Cost accounting systems involve tracking and analyzing all the financial transactions and expenses incurred by a business. This tool helps the company identify the areas where they are spending more money and offers insights on controlling those expenses. Developing a strategy for handling overhead expenses by prioritizing and analyzing the costs can lead to reducing overhead expenses and optimizing resources to maximize profitability.

To carry out ABC, it is necessary that cost drivers are established for different cost pools. 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. 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.