Determine cost driver

In some cases, the cost driver is static and does not increase as production grows. The business may not require additional personnel to ramp up production, and their cost actually drives down , as production increases. When determining the cost drivers in a business, set them into distinct categories based on the activity.

One common activity-based cost driver is purchasing materials. Production is impossible without the raw materials and this is an activity that will always factor into the overhead structure. Another common activity is purchasing equipment and machinery. Each machine is capable of producing a specific number of units in a given time period. To grow that number, additional machinery must enter the cost driver equation. The actual production and final product inspection are also common activity drivers that effect costs.

When determining the value of each activity, the business must evaluate the cost on a per unit calculation, when possible. Most cost drivers simply cannot be eliminated, without having a serious effect on the business. The production process is one area where technology is naturally influencing the activity-based costing formula however.

Automation is essentially taking the production activity-based costing and removing the human element. 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.

Additionally, an increase in technology often raises overhead costs. Should the company still be using a predetermined overhead application rate based on direct labor hours or machine hours?

A detailed analysis of the cost drivers will answer these questions. Another benefit of looking at cost drivers is that doing so allows a company to analyze all costs. A company can differentiate among costs that drive overhead and have value, those that do not drive overhead but still add value, and those that may or may not drive the overhead but do not add any value. For example, a furniture manufacturer produces and sells wooden tables in various colors.

The painting process involves a white base coat, a color coat, and a clear protective top coat. The three coats are applied in a sealed room using a spraying process followed by an ultraviolet drying process. The depreciation on the spraying machines and the ultraviolet bulbs used in the painting process are overhead costs.

These costs drive or increase overhead, and they add value to the product by increasing the quality. Costs associated with repainting or fixing any blemishes are overhead costs that are necessary to sell the product but would not be considered value-added costs. The goal is to eliminate as many of the non-value-added costs as possible and subsequently reduce overhead costs. Additionally, the appropriate level of assigning cost drivers needs to be determined. In some cases, overhead costs such as inspection increase with each unit inspected, and the costs need to be allocated on a per-unit level.

In other cases, the overhead costs, such as machine setup costs, are incurred each time a batch of products is manufactured and need to be allocated at the batch level. For example, the labor hours for the staff taking, fulfilling, and inspecting orders may increase as the number of orders increases, driving up the overhead. Furthermore, the costs of taking orders or of quality inspections can vary per product and may not be captured properly.

Technology improvements, including switching to automated processes for production, may decrease the labor hours of the production staff, driving the labor-related overhead downward but potentially increasing other overhead expenses. These activities—order taking, fulfillment, and quality inspections—are potential cost drivers associated with production, and they each drive the overhead at varying rates.

How does a company determine its cost drivers for indirect materials, indirect labor, and other overhead costs? To begin the determination of appropriate cost drivers, an accountant analyzes the activities in the product production process that contribute to the cost of that product. An activity is any action that consumes company resources, such as taking orders for a product, setting up machines to produce the product, inspecting the product, and providing customer support before and through the order process.

While the Orchestra product has more intricate materials and labor, it has fewer costs associated with requisitioning and conveying materials to the production line than the other products have. Articles Topics Index Site Archive. About Contact Environmental Commitment.

What is a Cost Driver? Examples of Cost Drivers Examples of cost drivers are direct labor hours worked, the number of customer contacts made, the number of engineering change orders issued, the number of machine hours used, and the number of product returns from customers. Average accounts payable calculation Accounting principles. Copyright