What is Activity Cost Driver
An activity cost driver is a factor that influences or contributes to the expense of certain business operations. In activity-based costing (ABC), an activity cost driver drives the costs of labor, maintenance, or other variable expenses. Cost drivers are essential in ABC, a branch of managerial accounting that allows managers to determine the costs to perform an activity at various activity levels.
BREAKING DOWN Activity Cost Driver
A cost driver is an activity that is the root cause of why a cost occurs. It must be applicable and relevant to the event that is incurring a cost. There may be multiple cost drivers responsible for the occurrence of a single expense. A cost driver assists with allocation expenses in a systematic manner that theoretically results in more accurate calculations of the true costs of producing specific products.
Examples of Cost Drivers
The most common cost driver has historically been direct labor hours. Expenses incurred relating to the layout or structure of a building or warehouse may utilize a cost driver of square footage to allocate expenses. More technical cost drivers include machine hours, the number of change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections.
Example of Cost Allocation
A factory has a machine that requires periodic maintenance. This maintenance incurs costs to be allocated to the products produced by the machinery. Therefore, the cost driver is identified and used as a base to distribute the costs. In this example, the cost driver selected is "machinery hours." It is determined that after every 1,000 machine hours, maintenance costing $500 is performed. Therefore, every machine hour results in an eventual 50 cents in maintenance costs that can be allocated to the product being manufactured based on the cost driver of machine hours.
Distribution of Overhead Costs
A cost driver exists to allocate manufacturing overhead. The correct allocation of manufacturing overhead is important for determining the true cost of a product. Internal management utilizes the cost of a product in the determination of the product's price. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity.
Subjectivity of Cost Drivers
Management selects cost drivers as the allocation base for distributing manufacturing overhead. There are no industry standards or regulations stipulating mandating cost driver selection. A cost driver is selected at management's discretion based on the associated variables relating to the expense being incurred.