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Cost Driver Know the Significance of Cost Drivers in Cost Accounting

what is a cost driver

In certain cases, increasing production to an optimal level may lead to economies of scale, resulting in reduced average costs. But in general, if the level of activity in the business is high, the cost will also increase and vice versa. omni calculator logo The drivers under this head are influenced by the business’s activity level, like the level of production and frequency of sales. But in general, the following three are the main types of cost drivers that a business can have.

Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. Doing this helps to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy and churn out higher profits. Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.

This method allows you to identify the current costs per unit for various products, services, and customers (if differentiated). A cost driver is the direct cause of a cost and its effect is on the total cost incurred. For example, if you are to determine the amount of electricity consumed in a particular period, the number of units consumed determines the total bill for electricity. In such a scenario, the number of units of electricity consumed is a cost driver. Keeping tabs on cost drivers makes it easier to determine the actual cost of production and make more accurate financial projections. Keeping tabs on activity cost drivers is important, as doing so can help boost efficiency and company profits.

  1. Due to sophisticated manufacturing and increased demands from customers, direct labor is no longer the main cost driver of indirect manufacturing overhead.
  2. Time-based drivers are costs that increase with the amount of time spent on a particular activity.
  3. Variable costs that vary with the volume produced or sold such as direct materials, direct labor, and variable manufacturing overhead.
  4. Failure to do so can lead to the closing of a business venture, due to poor cost computation, that may actually be profitable, or at least potentially profitable.
  5. ABC differs from traditional costing methods, which rely on mostly volume-based allocation methods.

Manufacturers that want to know the true costs of their products need to know what is driving their indirect manufacturing costs. For these companies it is not sufficient to merely spread overhead costs to products by using a single factor such as direct labor hours or production machine hours. In the past century, the root cause of indirect manufacturing costs has changed from a single cost driver (such as direct labor hours) to several cost drivers. Due to sophisticated manufacturing and increased demands from customers, direct labor is no longer the main cost driver of indirect manufacturing overhead. Examples of cost drivers include labor hours, materials used, degree of automation, number of machine setups, number of units produced, number of orders received, and overhead costs.

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After you get the figures, you would be able to see how your cost per unit has changed with changes in your production strategies. Cost driver can be any measurable input that affects the costs of a company, either directly or indirectly. Additionally, tracking drivers of cost can help organizations identify areas for cost reduction and streamline operations. There are other drivers of cost like regulatory drivers (tax and legal cost), supply chains or distribution drivers (cost of transportation), etc., depending on the type of business or industry the company is operating. Overheads will change if the organization expands its operation or increases its production or output capacity.