What are Cost Drivers?

Explanation

The cost driver is that variable or factor which has an effect and causes the relationship with the total cost. It is the cause and the cost incurred in its effect. 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 correlationCorrelationCorrelation is a statistical measure between two variables that is defined as a change in one variable corresponding to a change in the other. It is calculated as (x(i)-mean(x))*(y(i)-mean(y)) / ((x(i)-mean(x))2 * (y(i)-mean(y))2.read more is just a way to prove the relationship.

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Types of Cost Drivers

There are many types of cost drivers in cost accountingCost AccountingCost accounting is a defined stream of managerial accounting used for ascertaining the overall cost of production. It measures, records and analyzes both fixed and variable costs for this purpose.read more. As per traditional accounting, the manufacturing and indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc.read more are allocated on the predefined rate based on the activity performed.

  • Numbers of Set-UpsNumber of Machine HoursNumber of Processed OrdersNumber of Orders CompletedNumber of Labor HoursNumber of DeliveriesNumber of Calls TakenNumber 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.

Example of Cost Driver

Following is the cost structureThe Cost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more of XYC Inc. Please allocate the following costs based on the cost drivers.

Solution:

Allocation of cost on the basis for XYZ Inc:

Calculate Total of the Costs

Applications

This system is basically to compute the product costProduct CostProduct cost refers to all those costs which are incurred by the company in order to create the product of the company or deliver the services to the customers and the same is shown in the financial statement of the company for the period in which they become the part of the cost of the goods that are sold by the company.read more. In business, it is vital to find the cost of the product, to identify whether the business can make the required profits from producing those products. If the cost is higher than the revenue generated from the product sale, it will benefit the business. In contrast, if the costs are higher than the revenue generated, 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 performed. Only those costs should be assigned to a product that includes a particular activity in its production.It makes that allocation possible, and only then the real cost of the product being manufactured will be determined. Then the management would decide whether to enter the market or not and whether to produce the product.

Difference Between Cost Drivers and Cost Objects

  • Cost Object is the product’s, process, department, or customer-related management term, defining the costs originated from or is associated with. A cost objectA Cost ObjectA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. read more can be identified with a product, process, department, or customer and tracked back to why the cost was incurred.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

Advantages

  • 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 see a business’s various departments as one single business unit as these drivers create a relationship between the departments.

Disadvantages

  • 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 an incorrect selection of process.

Conclusion

Cost Driver is an essential source for allocating the costsAllocating The CostsCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. read more  of the product based on the activities performed to produce that product, which helps in finding the total cost of the product. The total cost of the product helps the management analyze the decision to produce the product and 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 it from the following articles –

  • What is Appraisal Costs?Incurred CostWhat are Indirect Expenses?Cost Basis Example