What Is an Activity Cost Driver?
An activity cost driver is an accounting term. A cost driver affects the expenses of certain business operations. In activity-based costing (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.
How Activity Cost Drivers Work
A cost driver directly influences a business activity. There may be multiple cost drivers associated with an activity. For example, direct labor hours are a driver of most activities or product manufacturing. If the cost of 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 service provision.
[Important: An activity cost driver, also known as a causal factor, causes the cost of an activity to increase or decrease; such a factor or driver could be a change in the cost of warehousing or a change in the level of production.]
Other, 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.
In a situation where a factory has a machine that 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
A cost driver 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 an accounting method that allocates both direct and indirect costs to business activities.
- A cost driver simplifies the allocation of manufacturing overheads, such as the costs of factory space and electricity.
- Management selects cost drivers based on the associated variables of the expense incurred.
Special Considerations: The Subjectivity of Cost Drivers
Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards or regulations stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.
[Fast Fact: 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.]