What Is an Activity Cost Driver?
An activity cost driver is an action that triggers higher or lower variable costs for a business. Sometimes referred to as a causal factor, it is associated with the managerial accounting concept of activity-based costing (ABC). Keeping tabs on activity cost drivers is important as it can help boost efficiency and company profits.
- An activity cost driver is an action that triggers higher or lower variable costs for a business.
- Activity cost drivers give a more accurate determination of the true cost of business activity by considering the indirect expenses.
- Keeping tabs on these fluctuating costs can help boost efficiency and company profits.
- Activity cost drivers are used in activity-based accounting (ABC).
How Activity Cost Drivers Work
A cost driver affects the cost of specific business activities. In ABC, an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.
There may be multiple cost drivers associated with an activity. For example, direct labor hours are a driver of most activities in product manufacturing. If the expenditure for labor is high, this will increase the cost of producing all company products or services. If the cost of warehousing is high, this will also increase the expenses incurred for product manufacturing or providing services.
Keeping tabs on cost drivers makes it easier to determine the actual cost of production and make more accurate financial projections.
More technical cost drivers are machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.
When a factory machine requires periodic maintenance, the cost of the maintenance is allocated to the products produced by the machine. For example, the cost driver selected is machinery hours. After every 1,000 machine hours, there is a maintenance expense of $500. Therefore, every machine hour results in a 50-cent (500 / 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine hours.
Distribution of Overhead Costs
Using cost drivers simplifies the allocation of manufacturing overhead. 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. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity.
Activity-based costing (ABC) is a more accurate way of allocating both direct and indirect costs. ABC calculates the true cost of each product by identifying the amount of resources consumed by a business activity, such as electricity or man hours.
Special Considerations: The Subjectivity of Cost Drivers
Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.
What Are Some Examples of Activity Cost Drivers?
Activity cost drivers include direct labor hours, the cost of warehousing, order frequency, and product returns.
What Do You Mean by Cost Driver?
Cost drivers are the activities that trigger business expenses.
What Is the Activity-Based Costing Method?
Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. Doing this helps to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy and churn out higher profits.
The Bottom Line
Examining activity cost drivers helps companies to reduce unnecessary expenses and get to grips with how much an order really costs. The importance of accessing this knowledge shouldn’t be understated. The ultimate goal is to maximize profits; a key way to accomplish this is by being aware of all expenses and keeping them in check.