Cost Drivers

Definition

Cost drivers are the factors that directly influence the incurrence of costs within an organization. They are the underlying causes that determine the level of resources consumed and the resulting costs associated with business activities or operations. Cost drivers play a crucial role in various managerial accounting concepts, including the estimation of variable and fixed costs, the application of job order and process costing methods, the calculation of activity-based product costs, and the analysis of overhead variances.

5 Must Know Facts For Your Next Test

1. Cost drivers are the primary factors that determine the level of costs incurred by a business, and they can be either volume-based or non-volume-based.
2. In job order costing, the primary cost drivers are the number of direct labor hours or machine hours required to complete a specific job or order.
3. In process costing, the primary cost drivers are the number of units produced or the number of direct labor hours required in each production process.
4. Activity-based costing (ABC) uses multiple cost drivers, such as the number of setups, the number of purchase orders, or the number of customer deliveries, to more accurately assign overhead costs to products or services.
5. Identifying and understanding cost drivers is crucial for accurately predicting future costs, making informed pricing decisions, and improving the efficiency of business operations.

Review Questions

• Explain how cost drivers are used in the estimation of variable and fixed costs, and how they can be used to predict future costs.
  • Cost drivers are the key factors that influence the incurrence of variable and fixed costs within an organization. For variable costs, the primary cost driver is typically the level of activity or production, such as the number of units produced or the number of direct labor hours required. By analyzing the relationship between the cost driver and the variable costs, businesses can estimate a variable cost equation and use it to predict future costs based on changes in the cost driver. Similarly, for fixed costs, the cost driver may be factors like the capacity of production facilities or the number of employees required, which can be used to estimate a fixed cost equation and forecast future fixed costs.
• Describe how cost drivers are used in the job order costing and process costing methods, and explain how they impact the tracing of product costs through the inventory accounts.
  • In job order costing, the primary cost drivers are the number of direct labor hours or machine hours required to complete a specific job or order. These cost drivers are used to trace direct costs, such as direct materials and direct labor, to individual jobs. Additionally, overhead costs are allocated to jobs based on the chosen cost driver, which could be direct labor hours, machine hours, or another appropriate measure. The use of cost drivers in job order costing allows for the accurate tracing of product costs through the inventory accounts, from raw materials to work-in-process to finished goods. In process costing, the primary cost drivers are the number of units produced or the number of direct labor hours required in each production process. These cost drivers are used to allocate costs to the various production processes, enabling the tracing of product costs through the inventory accounts as the goods move through the production system.
• Analyze how the identification and use of cost drivers is crucial for the implementation of activity-based costing (ABC) and the calculation of overhead variances.
  • The identification and use of cost drivers is fundamental to the success of activity-based costing (ABC). ABC assigns overhead costs to products or services based on the activities and cost drivers that actually cause the incurrence of those overhead costs, rather than using a traditional volume-based allocation method. By accurately identifying the cost drivers, such as the number of setups, the number of purchase orders, or the number of customer deliveries, ABC can more precisely allocate overhead costs to the appropriate products or services. This leads to a more accurate understanding of product or service profitability, which is crucial for informed decision-making. Additionally, the use of cost drivers is essential for the computation and evaluation of overhead variances. By analyzing the differences between actual and budgeted overhead costs in relation to the actual and budgeted cost drivers, businesses can identify the root causes of overhead variances and implement corrective actions to improve efficiency and control costs.

Related terms

Variable Costs:

Costs that vary in direct proportion to changes in the level of activity or production, such as direct materials and direct labor.

Fixed Costs:

Costs that remain constant regardless of changes in the level of activity or production, such as rent, insurance, and administrative salaries.

Activity-Based Costing (ABC): A costing method that assigns overhead costs to products or services based on the activities and cost drivers that actually cause the incurrence of those overhead costs.