What is an Activity Cost Driver?
An activity cost driver refers to actions that cause variable costs to increase or decrease for a business. Therefore, identifying what product/service is causing particular costs can help the business to become more profitable by better understanding the specific activities that are driving the costs.
Activity cost drivers include things such as labor hours, machine hours, and customer contacts. They are used in activity-based costing (ABC) – a segment of managerial accounting.
- Activity cost drivers are actions that cause costs to increase or decrease.
- Activity cost drivers are used in activity-based accounting (ABC).
- Allocating cost drivers appropriately is important in accurately determining the cost of producing a good or service, as well as making financial projections.
How Activity Cost Drivers Work
Activity cost drivers are specific activities that cause variable expenses to be incurred. One variable expense can comprise more than a single activity cost driver. For example, machine hours and labor hours can be activity cost drivers in the manufacturing of a product.
All variable expenses can be broken down and looked at by one or several activity cost drivers, which can also be influenced by several factors. For example, if the minimum wage increases, it can cause the cost of producing a product to also increase.
Examples of Activity Cost Drivers
- Direct labor hours
- Machine setups required
- Number of customer contacts
- Number of customer change orders
What is Activity-Based Costing (ABC)?
Activity-based costing (ABC) is a costing method where indirect costs are assigned to products and services. It is done by looking at which products demand particular costs. For example, under ABC, a manufacturing company may decide to allocate rent expense to each product based on the amount of space the machines that are utilized to produce that particular product uses. Improperly allocating the costs can result in poor decision-making.
Imagine that the previously mentioned manufacturing plant produced two items with the exact same price and sales volume. The direct costs for Item A and Item B are $1,000 per month and $500 per month, respectively. However, Item A used up 10% of the manufacturing space, while item B used up 90%. If rent is $1,000 per month, the total rent allocated to item B would be $900 (and $100 to item A).
Therefore, the total cost to produce item A is $1,100, and the total cost to produce item B is $1,400. While the above is a heavily-simplified example compared to a real-world situation, it shows the importance of allocating indirect costs to get a more accurate financial picture of a company.
Importance of Activity Cost Drivers
Looking at activity cost drivers can allow management to better understand a company’s expenses. By delineating the exact source of different expenses, companies can help to reduce or eliminate unnecessary expenses. Without proper allocation of the cost drivers, it can be meaningless to compare the costs of different products and services.
Activity cost drivers are also important in projecting costs. For example, if management receives a sales order for a certain number of units, they can pinpoint exactly how much it is going to cost to fulfill that order.
Choosing Cost Drivers
There are no accounting standards for how activity cost drivers should be allocated. They are only used as a tool to help management understand which activities are driving certain expenses and the true cost of producing particular products or services. Especially with larger and more complex businesses, cost drivers will always be an estimate.
Accountants who estimate cost drivers must possess a thorough understanding of what goes into the production of a particular good or service. They then determine a particular activity’s impact on the production of that product.
Imagine that McDonald’s needs to clean their ice cream machine after every 200 ice cream cones sold. In this instance, the cost driver would be the number of ice cream cones produced. The cost of cleaning the machine is $50.
Therefore, every cone produced results in 25 cents ($50 / 200 cones) of cost allocated to ice cream cones. The activity cost driver would be used in conjunction with others in determining the margin that McDonald’s is making on their cones.
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