What is a Cost Driver?

What is a Cost Driver?

A cost driver is an accounting term that is the unit of an activity that causes the changes in the total cost of the training, i.e., and it is the direct cause of a cost concerning the total cost incurred. A cost driver is the unit of activity that causes a business to go through cost.

A typical example of a cost driver refers to the cost of fuel for running a car, and the cost driver is the ‘number of kilometers run, which would lead to the consumption of fuel by the vehicle.

The total cost would be the ‘total cost of fuel’ incurred on the procurement of fuel. It is possible that there are many drivers of a particular cost item.

For example, labor is directly related to the cost of many activities involved in producing goods; therefore, when the labor cost is high, this would translate to a high cost of production.

Costing is an integral part of management accounting aimed at capturing the total cost of production by evaluating the total fixed cost element and variable cost of a company’s production.

It is used for carrying out informed business decisions by the company. The importance of costing in any organization cannot be overemphasized as it allows management to drill down to the causal effect of its production costs.

A good management accountant strips all cost elements into their unit form to ascertain which cost element contributes significantly to the production of products.

A cost driver is a link that relates the cost incurred in a particular item with the pool of costs that led to its incurrence. A cost driver has a causal effect as it has the propensity to increase or decrease cost levels. 

 Types of Costing

  • Direct Cost: This is the type of cost directly attributed to the production of a product. An example of a direct cost is the wages and salaries of labor and the cost of material used in production. Direct costs are traceable to a particular production unit and vary with production levels. 
  • Indirect Cost: These are the types of costs that can not be directly traced to a particular department, project, or activity in a production company. An example is a lightning and water. Production levels do not influence indirect costs as they are not traceable to a production unit.
  • Fixed Cost: This is a type of cost that doesn’t change with the level of production in the company. An example is a cost incurred on a lease. No matter how good or bad the company is doing, the fixed cost doesn’t change; therefore, a company should ensure that its production levels are worth 
  • Variable Cost: Variable cost is the opposite of Fixed cost. It changes as the level of production in the company changes, i.e., Variable cost rises as production rises, and it also falls as production falls. An example of variable cost is the packaging. The higher the number of items produced, the higher the cost of packaging.

Differences Between Fixed and Variable Cost

Cost
  1. Fixed Cost remains unchanged irrespective of the production level, while Variable Cost cost changes based on a production level.
  2. Fixed Cost is usually time-related while Variable Cost is volume related, e.g., Cost of leasing is time-bound while an increase in the cost of production is volume related 
  3. Fixed Cost changes per unit, i.e., the higher the fixed cost produced, the lower the fixed cost per unit. This shows that fixed cost per unit is inversely proportional to the output produced while Variable Cost per unit remains constant.
  4. Fixed Cost is a combination of all elements of cost that doesn’t change with production levels. These include: Fixed Production Overhead, Fixed Administration Overhead, and Fixed  Selling and Distribution Overhead, they are likely to be incurred regardless of the level of production while Variable Cost is a combination of Direct Material, Direct Labor, Direct Expenses, Variable Production Overhead, Variable Selling, and Distribution Overhead.
  5. Examples of Fixed Costs are Depreciation, Rent, Salary, Insurance, Tax, etc. While examples of Variable Cost are Material Consumed, Wages, Commission on Sales, Packing Expenses, etc.

Advantages of Costing 

  1. It helps in the preparation of financial accounts as it creates a guide as to the full extent of the cost incurred during the business cycle and serves to advise management’s decision.
  2. It aids in the prevention of fraud in financial statements as they are helpful in the government, shareholders, the creditors, etc 
  3. It helps in fixing of prices to products
  4. It helps in determining the reasons for increase or decrease in profit, i.e., identification of profit or loss
  5. Wastes, Losses, and inefficiencies are eliminated through a sound costing system. 

Disadvantages of Costing 

  1. The cost of the previous year isn’t the same as that of the current year; therefore, cost data are not so useful 
  2. Costing uses the system of estimates, therefore digits higher or lower than the actual digits may be provided, i.e., over absorption and under absorption 
  3. A costing system is expensive to set up, thereby adding to the already existing financial accounting system 
  4. Some of the pieces of information provided by a cost accounting system may be hard to understand on accounting personal 

Application of a Cost Driver in Computing a Product’s Cost

In a business enterprise, the vital determining factor if there will be continuity or not is COST. When the cost incurred in the production of goods is more than revenue, there is a high probability of the business closing down as it’s running on a loss.

But in a case where the revenue is higher than the cost incurred in production, there is profit and the possibility of expansion.

The Break-even point is the even cost incurred, and revenue is the same; here, the business can be shut down or expanded, which depends on other variables apart from fixed cost.

Failure to perform reliable cost/revenue analysis (viable costing methods are required to get the correct cost or a figure that is close enough to the actual cost) can lead to the closing of a business operation as a result of poor cost computation when it may be profitable.

The selling prices for a particular product are set through the total cost of production.

Therefore if the costs are incorrect, the profit predictions will also be inaccurate, and the whole accounting system of the organization in question will be erroneous.

We’ll be focusing on Activity Based Costing in this write-up 

What Is Activity-Based Costing(ABC)?

Cost

ABC is a method of costing in which the cost of activities is allocated to a particular production cost.

Hence, ABC is a method that uses the number of resources consumed by each activity as a base for the computation of costs associated with each line of production or product.

This makes ABC an accurate way of allocating direct and indirect costs. From the above, it shows that cost drivers are the most relevant in the ABC costing system. 

When reviewing the total cost that each activity consumed, we allocate the total cost to a particular product or line of products based on the resources consumed by cost drivers; this would then help to streamline the actual cost that was incurred by the cost driver’s cost unit.

A cost driver is a reason why a particular cost occurred. It creates the cost of the activity of driving it. ABC gives each production cost breakdowns, and this makes it easy to see profitable products.

A manufacturing business is an example of a company with high overhead costs that uses activity-based costing to get a clearer picture of how money is used in the organization.

Customers, Products, and Channels of Production Consume Activities While Activities Consume Resources

In cases of resource constraints, the lower profitable order can be eliminated, and the profitability of each customer can be quickly evaluated using cost drivers. Resources should be allocated in proportion to profitability or the most profitable activities. 

For example: In the production process, machines are used and the machine hours used to determine the total cost of operating the machine, which is a function of how much money is to be charged per hour of the machine’s usage.

If a machine is out to use for 20 hours at the cost of £20 per hour, then the total cost that will be charged to the output of that particular time is £400. The more the labor hours being used, the higher the cost.

If the particular machine in question requires maintenance amounting to £2,000 after operating 4,000 hours, the maintenance cost per every hour of machine operation is 50 pounds. (£2,000/4,000 hrs.).

 Therefore, Machines Can Be Referred to As Cost Drivers.

Another determinant of the total cost is the cost per hour. In a situation where the cost per hour rises, the cost associated with the output will also be high. A lot of variables are determinants of the cost of production.

The indirect costs associated with a line of production are allotted based on a ratio or a weight based on the products that were subjected to quality control. An example of such costs is quality control cost.

The Main Challenge Facing Abc Costing Is that It Apportions Fixed Costs as If They Were Variable. 

Because of this, an inaccurate figure of the total cost may be given, and the inaccuracy is determined by the period it takes to regain back the initial fixed cost.

The higher the cost, the lower the profits in the first year of operations and as more costs are absorbed, there will be more profits. 

Overall, any cost that can’t be traced should be deducted from contributions or operating profits. But it shouldn’t be allocated to any individual product without any analytical base.

In summary, when using activity-based costing(ABC), you can:

  • Take the direct and overhead costs of creating each product into consideration 
  • Acknowledge that different indirect products require other direct products 
  • Set prices accurate 
  • Reduce some overhead costs 

Types of Drivers in Cost Accounting

Cost

There is a list of types of cost drivers in cost accounting. The indirect costs of manufacturing overheads are allocated to the production cost based on a predetermined rate in a traditional accounting system.

Cost drivers are almost irrelevant in determining the contribution in some accounting systems.

Below are examples of types of drivers in cost accounting:

  1. Many hours direct labor worked: Labour costs are directly proportional to production; therefore, the driver could be measured in the number of hours worked to achieve production. The measure of hours worked is essential to ascertain the value of time committed to production.
  2. The number of customers: This could be a cost driver in a service industry like a call center, and it could be measured considering the number of customers whose issues were resolved by the call Centre group.
  3. The number of machine-hours worked: The machine operations could be measured in terms of the number of hours the machine has been put to use, which could be used to monitor the output of the machine and the production levels.
  4. The number of return inwards from customers: Sales return is a measure of the number of complaints about products made by customers and also assists in measuring the process the production team would seek to ensure that products are perfect.
  5. The number of set-ups: This is a driver that measures the setup for utilizing machines for production.
  6. The number of orders processed: An inventory system creates an avenue that measures the number of orders successfully processed by the customer service agents.
  7. The number of completed orders: This is a measure of orders that eventually got to the last unit in the production chain. It is a driver for the cost of the person who ensures the completion.
  8. The number of outputs: production output could assist in measuring the production level of machines and the corresponding production of goods in the inventory to associate relevant cost measures to it.

Activity-Based Costing vs. Traditional Costing 

ABC is an alternative to traditional costing. Traditional costing is more straightforward than ABC but less specific.

Going with conventional costing when producing a few products is advised as, unlike Activity Based costing, it doesn’t seek to delineate cost elements to their drivers, but rather it sets total costs against revenue which might make it challenging to streamline the cost elements that results in increase or decrease in cost levels.

Traditional costing can give an inaccurate cost of making each product as some production-related activities use more overhead expenses than others.

Activity-based costing (ABC) is used for reporting internally (e.g., to managers). And traditional costing may also be used for reporting externally (e.g., to investors).

Significance of Cost Drivers in Cost Accounting

What ascertains the total cost of a particular activity should be examined in totality to ensure that a proper apportionment base is used.

Cost drivers use a cause-effect relationship, and a more relevant driver should be looked for if the relationship cannot be established. 

Elements that determine the total cost of a particular activity must be analyzed in-depth to ensure that a proper allocation base is used, guiding the manager’s future decisions concerning the process.

It is moody to note that, as stated earlier, Cost drivers utilize a cause-effect relationship, i.e., a correlation between cost and the elements that are driving cost; therefore, if the relationship cannot be established, then a more relevant driver should be looked for.

Below Is an Example of Cost Allocation that Is Sorely Based on Cost Drivers

We will work with the example below to better understand how cost drivers are used in deriving a line of a product’s total cost and how it is used in deriving each product line.

The following information is for the three production lines of XYZ Company, which uses Activity-Based Costing:

Activity Cost(£)Cost Driver(£)
Set-up10,000Number of setups 
Machine Maintenance15,000Machine hours
Customers Served 20,000Number of customers
Project AProject BProject CTotal
Number of setups23510
Number of machine hours 80100120300
Number of customers 15152050

The company set out to produce 30 units of product A, 40 units of product B, and another 50 units of product C. You are required to Calculate the cost per unit of each product.

Cost per Set-Up

Using the number of set-ups as the basis for allocation of set-up cost to products, the cost per set-up will be:

  • Total set-up cost = £10,000
  • Total number of set-ups = 10
  • Cost per set-up = 10,000/10 = £1,000
  • Set-up cost associated with product A = 100 x 20 = £2,000
  • Set-up cost associated with product B = 100 x 30 = £3000
  • Set-up cost associated with product C = 100 x 50 = £5,000

Cost per Machine Hour

  • The total cost associated with machine maintenance = £15,000
  • Total number of machine-hours = (80+100+120) = 300 hours
  • Cost of each hour of machine maintenance = 15,000/300 = £50
  • Machine maintenance cost associated with product A = 80 x £50 = £4,000
  • Machine maintenance cost associated with product B = 100 x £50 = £5,000
  • Machine maintenance cost associated with product C = 120 x £50 = £6,000

The Cost Associated with Each Customer Served

  • The total cost associated with the number of customers served = £20,000
  • Total number of customers served = 50
  • Cost per each customer served = £20,000/50= £400
  • Customer service cost associated with product A = 15 x £400 = £6,000
  • Customer service cost associated with product B = 15 x £400 = £6,000
  • Customer service cost associated with product C = 20 x £400= £8,000

From the above cost drivers, the cost incurred by the company can be allocated to the products as follows:

Product A

Set-up + Machine Maintenance + Customer Service =

(£2,000 + £4,000+ £6,000) = £12,000

Product B

Set-up + Machine Maintenance + Customer Service =

(£3,000+ £5,000+ £6,000) = £14,000

Product C

Set-up + Machine Maintenance + Customer Service =

(£5,000 + £6,000 + £8,000) = £19,000

The Cost Associated with Each Unit Produced

  • Cost per unit of product A = Total cost/Number of units = £12,000/30= £400
  • Cost per unit of product B = £14,000/40= £350
  • Cost per unit of product C = £19,000/ 50= £380
  • Cost per unit of product A = Total cost/Number of units = £12,000/30= £400
  • Cost per unit of product B = £14,000/40= £350
  • Cost per unit of product C = £19,000/ 50= £380

Conclusion 

Costing is very important in management accounting as it helps an organization to understand all the elements of cost that contribute to its production of output.

The variable element( that varies with production level) and the fixed cost ( that is incurred regardless of output) are measured in a bid to understand their pattern and how much is incurred to achieve production.

Cost Driver aims to capture the total cost of production by evaluating the total and variable cost of a company’s production.

It is essential for the allocation of costs of the product based on the activities performed in the production of the product.

The total cost of the product helps in the determination of the selling price of the product customers will be willing to pay.

The drivers are estimated as they relate to the total cost using the Activity Based Costing (ABC) to estimate the cost associated with each production activity.