Activity Cost Driver: Definition and Examples

what is a cost driver

Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Ideally, a cost driver is an activity that is the root cause of why a cost occurs.

  1. If more units are produced, material and labor costs will increase if the workers are paid on the biases of units produced.
  2. All of our content is based on objective analysis, and the opinions are our own.
  3. Because of this fact, it may give an inaccurate figure of the total cost, and the inaccuracy depends on the period of time required to recoup back the initial fixed cost.
  4. Cost drivers follow a cause-effect relationship, and if the relationship cannot be established, then a more relevant driver should be looked for.
  5. If the costs equal revenue, then the business is at a point of indifference and it can be closed or continued depending on other variables apart from cost or how costs can possibly be adjusted.

Staff costs that are not directly linked to the production or sale of products are usually treated as fixed cost drivers. Overhead drivers or fixed cost drivers are expenses that remain fixed regardless of the production level or other activities (at the current max capacity excluding direct overhead cost). When a factory machine requires periodic maintenance, the maintenance cost is allocated to the products produced by the machine. Therefore, every machine hour results in a 50-cent (500 ÷ 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine hours.

All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Stay the same regardless of how many units you produce or sell, as long as your company keeps operating at 100%. Sometimes, they can rise just because you have an increase in sales volume and it makes your insurance premiums higher than your regular rate which you originally pay every year. As you increase the number of outlets to open new markets and attract more customers, your company’s cost will increase as well.

Activity Cost Driver: Definition and Examples

This cost driver is used in companies that operate more than one outlet, such as retail shops or restaurants. This method helps managers evaluate costs incurred by the business activities, identify the major sources of the costs, and determine what are the risks of an accounting career what activities they should undertake to reduce or eliminate them. Generally, any untraceable cost should be subtracted from the contribution or the operating profit but not allocated to individual products without any logical base.

Total production costs are used to set the selling prices for particular products. Thus, if the costs are inaccurate, the profit forecasts will not be accurate, and the whole accounting system of the particular organization will be subject to errors. In a business venture, the major determinant of whether there will be continuity or discontinuity is cost. If the cost of production exceeds the revenue derived from a sale, there is a great probability of the business closing down. If the costs are less than revenue, there is profit and a probability of expansion. If the costs equal revenue, then the business is at a point of indifference and it can be closed or continued depending on other variables apart from cost or how costs can possibly be adjusted.

Cost Drivers are the costs that go up and down depending on the number of units you produce or sell, and they affect your business’s bottom line. For this kind of cost driver, it can be raw materials and other items sold in bulk such as food ingredients used in fast-food restaurants, and the price of gas for a gas station. For any business to become profitable, it needs to know which activities use the most resources and how they can be streamlined to make resource consumption more efficient.

Example Of A Cost Allocation Based On Cost Drivers

If a business owner can identify the cost drivers, then the business owner can more accurately estimate the true cost of production for the business and then determine the per-item and batch-level costs. In ABC, an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.

what is a cost driver

Access and download collection of free Templates to help power your productivity and performance.

Why You Can Trust Finance Strategists

Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. A company, XYZ, wants to add a new product to its product line and narrows the choice to two products, A and B. Units that significantly impact the cost of a business or a particular activity of the business. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.

Overhead Drivers

That’s why a retail business hires additional staff when there is an increase in the number of customers. It also includes the wage rate per person or for a specific group of employees. A basic example of cost-driving is linking total sales traffic with the number of staff working outside the store. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

Finance Strategists has an advertising relationship with some of the companies included on this website. We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own.


Leave a Reply

Your email address will not be published. Required fields are marked *