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Activity cost drivers are associated with the managerial accounting concept of activity based costing where job activities are divided in to cost pools based on.
Cost drivers are the elements of a business that cause an overhead cost against the goods manufactured or services provided. Some cost drivers are necessary and unchangeable while others place a high than needed overhead cost against production. These unnecessary cost drivers ultimately drive down the margins and revenue produced.
Locating Cost Drivers
Before you can determine the cost driver, you must first locate the cost objects. These are the actual points of cost incurred and the activities that create the costs. For example, if you produce a product that requires hazardous material designations for transport, you will incur a fee to transport the materials on public roadways.
This fee is the cost object, and it is difficult to distribute that cost across the business, as it fluctuates, based on the level of production and transportation activity. The activity changes your overhead and acts as a cost driver that adjusts the cost of production and bringing the product to market.
Essentially, each normalized cost incurred from the start of production to the finished product falls in the cost driver category. This varies somewhat, based on the business model, but many manufacturing companies have similar cost drivers, such as buying raw materials and assembling the products. These costs are almost always recurring and necessary to operate the production side of the business.
Determine the Value of Activity Based Costing
The hard number placed on each activity is always subject to change. In most cases, the cost drivers rise accordingly, as more units are produced and the business will simply factor these costs into their overhead structure.
The rising cost is relative and will not increase the price of each unit, as it functions in a relative manner. In some cases, the cost driver is static and does not increase as production grows. The business may not require additional personnel to ramp up production, and their cost actually drives down, as production increases.
Choose Activity-based Categories
When determining the cost drivers in a business, set them into distinct categories based on the activity. One common activity-based cost driver is purchasing materials. Production is impossible without the raw materials and this is an activity that will always factor into the overhead structure.
Another common activity is purchasing equipment and machinery. Each machine is capable of producing a specific number of units in a given time period. To grow that number, additional machinery must enter the cost driver equation. The actual production and final product inspection are also common activity drivers that effect costs.
When determining the value of each activity, the business must evaluate the cost on a per unit calculation, when possible.
Eliminating the Unnecessary Cost Drivers
Most cost drivers simply cannot be eliminated, without having a serious effect on the business. The production process is one area where technology is naturally influencing the activity-based costing formula however.
Automation is essentially taking the production activity-based costing and removing the human element. This essentially makes production and equipment the same thing. The cost of operating and maintaining the equipment falls into the same bucket as production, when automated. Any hands-on assembly is a new activity cost driver.
One major focus of most manufacturing companies is the deep analysis of these activities in an effort to make them more efficient. Reducing the overhead associated with each cost driver creates a higher margin on the actual product, and the company stands to benefit with increased revenue.
References (3)
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About the Author
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Zach Lazzari is a freelance writer with extensive experience in startups and digital advertising. He has a diverse background with a strong presence in the digital marketing world. Zach has developed and sold multiple successful web properties and manages marketing for multiple clients in the outdoor industry. He has published business content in Angling Trade Magazine and writes white papers and case studies for multiple corporate partners.
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Lazzari, Zach. 'How to Determine Cost Drivers.' Small Business - Chron.com, http://smallbusiness.chron.com/determine-cost-drivers-40992.html. 28 March 2019.
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Abstract
The goal of any cost management system is to provide relevant and timely information to management. This information supports better management of corporate resources in production of products or provision of services, and improves competitiveness in terms of costs, quality, and profitability. In this context, a cost management system can also be viewed as a planning and control management system (Berliner and Brimson 1988). Cooper (1988a, 1988b, 1989a, 1989b) provided a comprehensive discussion of activity-based costing (ABC), following the pioneering work of Kaplan (1983, 1984). Extension of ABC to the service industry was provided by Rotch (1990). ABC has also been extended into activity-based management (ABM) to include other considerations, such as customer profitability, manpower utilization, distribution channels, and other management issues. Thus, ABC is the information system that reveals the cost and profitability structure of products and services in an organization, while ABM describes the actions taken to improve quality and reduce costs and cycle time, once information about activities' costs is known. In this article, ABC is used as a generic concept without any loss of generality. An ABC system achieves improved accuracy in estimation of costs by using multiple cost drivers to trace the cost of activities to the products associated with the resources consumed by those activities. In this respect, a cost driver is an event, associated with an activity, that results in the consumption of firms' resources. Since the number of events performed in a firm is often vast, it may not be cost-effective to use a distinct and different cost driver for each activity. Thus, many activities may be grouped into a single driver to trace the costs of all the grouped activities for a product or service. For instance, each setup may be associated with a single cost driver that accounts for moving, grouping, sequencing, and segmenting. At the same time, there may be other competing cost drivers, such as setup hours, better correlated with the resources consumed by these grouped activities. In activity-based costing, these different cost drivers are not necessarily all proportional to unit volume, in contrast to traditional volume-based cost systems (Kaplan 1988, O'Guinn 1990, Dewan and Magee 1992). 'The art of designing an ABC system can be viewed as making two separate but interrelated decisions about the number of cost drivers needed and which cost drivers to use. These decisions are interrelated because the type of cost drivers selected changes the number of drivers required to achieve a desired level of accuracy' (Cooper 1989a, 1989b). In this article, we provide an optimization model that balances savings in information processing costs with loss of accuracy. We show how to determine the number of drivers, and identify the representative cost drivers. The model is formulated as an integer program and is solved efficiently by using a composite greedy algorithm.