What is an activity cost driver?
An activity cost driver is an accounting term. A cost driver affects the cost of a specific business activity. In the cost-per-activity (ABC) calculation, an activity cost driver influences labor, maintenance or other variable costs. Cost drivers are essential in ABC, a branch of management accounting that allocates the indirect costs, or overhead, of an activity.
Operation of activity cost drivers
A cost driver directly influences a commercial activity. There can be several cost drivers associated with an activity. For example, direct work hours are a driver of most product manufacturing activities. If the cost of labor is high, it will increase the cost of producing all of the company’s products or services. If the cost of warehousing is high, it will also increase the costs of manufacturing products or providing services.
An activity cost driver, also called a causal factor, increases or decreases the cost of an activity. An example is a change in the cost of storage or a change in the level of production.
The most technical cost drivers are machine hours, the number of technical change orders, the number of customer contacts, the number of product returns, the machine configurations required for production or the number of inspections. If a business owner can identify the cost drivers, he can more accurately estimate the true cost of producing the business.
Key points to remember
- The cost-per-activity (ABC) calculation is an accounting method that allocates direct and indirect costs to commercial activities.
- A cost driver simplifies the allocation of overhead manufacturing costs, such as plant space and electricity costs.
- Management selects the cost drivers based on the variables associated with the expenses incurred.
When a factory machine requires periodic maintenance, the cost of maintenance is charged to the products produced by the machine. For example, the selected cost driver is the number of machine hours. After every 1,000 hours of use, a maintenance fee of $ 500 is charged. Therefore, each machine hour results in a maintenance cost of 50 cents (500/1000) allocated to the product being manufactured based on the cost factor of the machine hours.
Allocation of general expenses
A cost driver simplifies the allocation of manufacturing overhead. The correct allocation of manufacturing overhead is important in determining 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 specific cost drivers has a direct impact on the profitability and operations of an entity.
Calculation of costs by activity (ABC) is a more precise way of distributing direct and indirect costs. ABC calculates the real cost of each product by identifying the amount of resources consumed by a commercial activity, such as electricity or working hours.
Special considerations: the subjectivity of cost drivers
Management selects the cost drivers as the basis for the allocation of manufacturing overhead. No industry standard specifies or mandates the selection of cost drivers. Company management selects the cost drivers based on the expense variables incurred during production.