Introduction
Cost drivers are those factors which contribute to adding or reducing cost in any activity or process. However, they form a starting point for apportioning costs in cost accounting and are fundamental to fiscal business ounsel.
The objectives of conducting cost analysis include increasing effectiveness of utilization of resources, increasing the level of rationality of organizational decisions, and increasing the efficiency of organizational performance.
Definition of Cost Drivers
A cost driver is any activity, event or factor which has an effect on the cost of doing business. It links the cost incurred to the activity level through stating that the total direct costs of activity will be assigned to the cost object proportional to the activity level.
Cost drivers are applied in ABC to spread out indirect costs during the calculation of costs of products or services.
Cost Driver Importance in the Cost Accounting
Accurate Cost Allocation: The allotting of indirect costs to the cost of products or services can be made with a high degree of accuracy once cost drivers are identified.
Enhanced Decision-Making: Managers are also able to understand cost determination to enable them to make right decisions in choosing the right prices, establishing budget to be used and even allocation of resources.
Operational Efficiency: Hence, the application of key cost drivers helps the organization in the elimination of secondary cost.
Strategic Planning: Understanding cost behavior is particularly useful in planning for future growth and investment and therefore cost driver analysis can be useful to a company.
Utilization of Cost Allocations in Cost Management
1. Activity-Based Costing (ABC)
Activity-based costing is an approach that determines the appropriate overhead and indirect cost of a product, a service or a customer by assigning cost drivers. This is in contrast to traditional approaches to costing where resources form the basis of the cost drivers.
Steps in ABC:
- Identify Activities: What are core business processes, or LLs that cost time and money?
- Assign Costs to Activities: Identify cost drivers by linking costs to activities based on usage of resources.
- Determine Cost Drivers: Discuss the factors that explain the fluctuations in activity-based costs.
- Allocate Costs: In most cases, cost drivers are useful in allocating costs to products or services.
2. Budgeting and Forecasting
Cost driver analysis helps in budgeting to the extent of which costs might go up or down depending on activities or operations. The point is that cost drivers improve the accuracy of the forecasting.
3. Performance Measurement
Thus, using cost driving factors, it is possible to examine the organizational performance at different tiers. For example, monitoring the performance of various business production lines or outcome of marketing strategies.
4. Cost Control and Reduction
Recognising cost influential factors enables a business to manage costs that relate with quality delivery and find ways of cutting on these costs.
Types of Cost Drivers
Cost drivers can be classified based on their nature and the type of activity they influence:
1. Volume-Based Cost Drivers
These are associated with either the production rate, or the number of products manufactured. Examples include:
- Direct labor hours
- Machine hours
- Units produced
2. Costs that vary in volume with the number of transactions that take place in an organization.
These are based of the number of transactions or activities performed. Examples include:
- Number of purchase orders
- Number of customers who have been invoiced
- Number of shipments
3. Duration-Based Cost Drivers
These are linked with the time that should be used on an activity. Examples include:
- It also sun that time spent on customer support
- Hours of machine operation
4. Intensity-Based Cost Drivers
These relate to the level of activity such as; whether it is difficult, time consuming, or energy demanding activities. Examples include:
- Specialized training hours
- High-cost material usage
Significance of Cost Drivers
1. Improved Cost Accuracy
Variable costs make it possible to spread costs in direct proportion to resource usage so that better product or service costs are achieved.
2. Enhanced Resource Utilization
It is easy to see that understanding cost drivers help in managing resources by avoiding wastage of resources in a business.
3. Strategic Pricing
Understanding cost drivers enables firms to price their products, therefore increasing their ability to be profitable.
4. Informed Decision-Making
Used for cost control, cost driver analysis is also helpful in big strategic choices like outsourcing, improvement of some processes, and capital expenditure.
5. Competitive Advantage
Control of costs through cost drivers noted above offers a competitive advantage since costs can be done cheaply and efficiently.
Let me now illustrate an example of cost allocation using cost drivers
Total Cost = $ 2m Cost Driver: Number of units of product sold; Allocation Base: # of units of product sold Shoes = $ 800000; Ropes = $400000Vehicle = $400000; Accessories = $ 800000.
Scenario:
A manufacturing company produces two products: Product A and Product B. Fixed costs are $100, 000, which are the costs of running the company such as electricity bill, building maintenance and other office expenses. These costs have a relation with the number of hours the machines operated and the certain orders for production.
Allocation:
- Allocate Overhead Based on Machine Hours:
- Rate per machine hour = $100,000 / 5,000 = $20 per hour
- Product A: 2,000 × $20 = $40,000
- Product B: 3,000 × $20 = $60,000
- Allocate Overhead Based on Production Orders:
- Rate per order = $100,000 / 200 = $500 per order
- Product A: 50 × $500 = $25,000
- Product B: 150 × $500 = $75,000
Conclusion
Activation of cost drivers is significant for cost accounting. When cost drivers are properly identified and analyzed, a company is able to autonomously assign costs more appropriately, improve organizational processes and perform strategic planning comprehensively.
In whatever way that it is done through Activity Based Costing, or Budgeting, or Performance Measurement, cost drivers are therefore very critical in the improvement of financial management and the realization of sustainable profits and other goals.
Frequently Asked Questions (FAQs)
1. What is the major difference between cost drivers and cost objects?
Cost Drivers: The remaining factors have an effect on cost of an activity.
Cost Objects: Objects or activities (product, services, or division) to which cost is charged.
2. How cost drivers in a business organization affect its profitability should now be questioned.
It is with concern to costs that cost driving mechanisms determine the distribution of costs, cost configuration, and then costs and, consequently, profitability. Consequent identification of cost drivers guarantees effective usage of resources hence improving the financial results.
3. Can cost drivers be variable or fixed?
Yes, cost drivers can vary, for example, because of innovative solutions or updates in production and business, or customers’ requests.
4. What can pose difficulties in the process of identification of cost drivers?
- Lack of data or resources
- Complexity in operations
- Reluctance to adopt current techniques in costing
5. According to Gerry and Parnell ‘Is activity-based costing suitable for all organizations?’
ABC may not offer adequate efficiencies for certain small organisations that undertake relatively simple processing because the system is complex and expensive to put into practice.