Friday, 20 January 2012

Cost Driver

Cost Driver:
In accounting, a cost driver is a factor that incurs cost. Cost drivers are used to allocate variable and indirect costs to production activities or output. In order to compute the full cost of production, it is necessary to include indirect costs as well as direct costs. But because indirect costs, such as variable overhead, are not directly traceable to production activities, in order to apply these costs to production activities they must be allocated according to a cost driver rate. The cost driver rate is the rate at which indirect costs are applied to production activities, based on the activity of the cost driver.

Choosing Cost Drivers:
An indirect or variable cost may have several possible cost drivers. Traditional costing methods allocate indirect costs to production activities based on volume of output. Activity-based costing allocates indirect costs to particular production activities related to that cost.

When deciding which cost driver to use in terms of allocating indirect cost, it is necessary to consider the cause-and-effect relation between the cost and the cost driver, and whether or not the cost driver activity is easily measurable. It is also necessary to consider the cost behavior of the relevant cost, which refers to the cost’s response to the activity of the driver. The relationship between costs and cost drivers can also be approximated using regression analysis.

Cost drivers can be used at differing hierarchical levels. For example, an indirect or variable cost may be relevant at the unit level, the batch level, the product level, the customer level, or the facility level. Once the appropriate hierarchical level is determined, it is necessary to choose a cost driver activity at that level in order to allocate the indirect or variable cost.

Cost Driver Rates:
A cost driver rate is the amount of indirect or variable cost that is assigned to each unit of cost driver activity. For example, indirect overhead may be applied to
direct labor hours as $50 dollars per hour. In this case, for each hour of direct labor required for production, the company would allocate $50 of indirect overhead costs to the production activities or output.

Cost Driver Examples:
For illustrative purposes, below are some examples of indirect or variable costs as well as relevant cost driver bases for these costs.
Cost      Cost Driver 
Maintenance expense    Machine hours
Fuel costs     Miles traveled
Electricity expense    Hours of factory operation
Material handling expense   Tons of material handled

Source: Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008

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