What are Cost Drivers?
A cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity.
The cost driver is that variable or factor which has an effect and causes the relationship with the total cost. This is the cause, and the cost incurred is the effect of it. Its analysis means identifying all the possible cost drivers for a particular type of activity or cost etc. and explains their cause and effect relationship with the event. It should be understood that correlation is just a way to prove the relationship.
Types of Cost Drivers
There are many types of cost drivers in cost accounting. As per traditional accounting, the manufacturing costs and indirect costs are allocated on the predefined rate based on the activity performed.
- Numbers of Set-Ups
- Number of Machine Hours
- Number of Processed Orders
- Number of Orders Completed
- Number of Labor Hours
- Number of Deliveries
- Number of Calls Taken
- Number of Rides
These are not just the only types, but there may be many other types of cost drivers based on the type of activity being performed and the basis of division of that activity in terms of cost to be allocated to various departments.
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Example of Cost Driver
Following is the cost structure of XYC Inc. Please allocate the following costs based on the cost drivers.
Allocation of cost on the basis for XYZ Inc:
Calculate Total of the Costs
This system is basically to compute the product cost. In business, it is vital to find the cost of the product, to identify whether the business can make the required profits from the production of those products. If the cost would be higher than the revenue generated from the product sale, then it would be in the benefit for the business, whereas if the costs are higher than the revenue generated, than the business would have to rethink the decision to go for the production. Now in defining the product cost, these cost drivers play an essential role. It establishes the basis on which cost is to be allocated, which will ultimately result in the total cost of a product.
Why It’s Important?
- As mentioned above in the application of cost drivers, it is evident to know the cost of the product before entering the market to pre-identify whether the company can make profits out of the products they propose to sell.
- This application is essential to identify the cost allocable to various products as the cost is allocated based on the activities being performed, and only those costs should be assigned to a product that includes a particular activity in its productions.
- It makes that allocation possible, and only then, the real cost of the product being manufactured will be determined. Then the management would take the final decision on either to enter the market or not, whether to produce the product or not.
Difference Between Cost Drivers and Cost Objects
- Cost Object is the product’s, process, department, or customer-related management term, which defines that the costs originated from or is associated with. A cost object is something that can be identified with a product, process, department, or a customer and can be tracked back to why the cost was incurred.
- Whereas, this is the basis on which the cost incurred can be allocated to the product, department, process, or customer. The difference is why the cost was incurred and on what basis to allocate the incurred cost. It is the two phases of a single chain of production.
- It provides a competitive edge to the business as they give a precise distribution of cost based on activities performed.
- These are an advantage for a product as they bring out the actual cost incurred on the products based on the correct allocation of the processes or activities.
- It improves the relationship between the departments, as there are many common activities and processes which are performed for in various department.
- It helps management to see the various departments of a business as one single business unit as these drivers create a relationship between the departments.
- It is a complex process, and not every business can apply the cost drivers in its activities.
- It is hard to determine the exact basis for the cost drivers to get the actual costs, which will defeat the ultimate goal of the business to find the actual cost of the product.
- Cost drives application requires a thorough understanding of the cost functions. Otherwise, it would either be a selection of the wrong basis of allocation, or it would be an incorrect selection of process.
Cost Driver is an essential source for allocating the costs of the product based on the activities performed to produce that product, which in total helps in finding the total cost of the product. The total cost of the product helps the management to analyze the decision to produce the product and also to determine the selling price of the product which the customers will accept and be ready to pay.
This article has been a guide to What are Cost Drivers & its Definition. Here we discuss why cost drivers are essential and examples along with types, applications, advantages, and disadvantages. You can learn more about from the following articles –