Discuss the factors affecting the selection of cost drivers.
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Answer:
What is a Cost Driver?
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.
Cost Driver - Different Types
Application of a Cost Driver in Computing a Product’s Cost
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 on how costs can possibly be adjusted.
In order to make rational business decisions, you require viable costing methods to get the correct cost or a figure which is close enough to the actual cost for you to perform reliable cost/revenue analysis. 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.
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.
Our main focus here will be Activity-Based Costing (ABC).
Activity-Based Costing (ABC)
An activity’s costs can be allocated to a particular production lot, and this makes activity-based costing an accurate way of allocating both direct and indirect costs. It is a method of computing costs associated with each product or line of production in a company based on the amount of resources consumed by each activity.
As a result, cost drivers are most relevant in the ABC costing system. The cost of each activity is apportioned to specific products or lines of production, based on resources consumed by cost drivers. A cost driver is a factor that creates or drives the cost of the activity. It is the root cause of why a particular cost occurred.
For example, in most operations machines are used and, thus, the machine hours used determines the total cost of operating the machine depending on how much money is charged per hour. If a person operates a machine for 10 hours at a cost of $10 per hour, then the total cost that will be charged to the output of that particular time is $100. The more labor hours used, the higher the cost.
If the particular machine we are referring to requires maintenance costing $1,000 after operating 2,000 hours, then the maintenance cost per every hour of machine operation is 50 cents ($1.000/2.000 hrs.). Thus, machine hours can be classified as a cost driver.
Generally, any untraceable cost should be subtracted from the contribution or the operating profit but not allocated to individual products without any logical base.
Types of Drivers in Cost Accounting
In a traditional system of accounting, the indirect costs or manufacturing overheads are allocated to the production cost based on a predetermined rate. In some accounting systems, cost drivers are almost irrelevant in determining the contribution.
Number of set-ups
Number of machine hours
Number of processed orders
Number of orders completed
Number of labor hours
Number of orders packed and delivered
Significance of Cost Drivers in Cost Accounting
Whatever determines the total cost of a particular activity should be analyzed in depth to ensure that a proper allocation base is used. Cost drivers follow a cause-effect relationship, and if the relationship cannot be established, then a more relevant driver should be looked for.
Example of a Cost Allocation Based on Cost Drivers
We are going to look at the following example in order to get a clear picture of how cost drivers are used to derive each product’s or line of production’s total costs.
Cost Driver
The company plans to produce 300 units of product A, 400 units of product B, and 500 units of product C. Compute the cost per unit of each product.
Cost per set-up
Based on the number of set-ups as the basis of allocating set-up cost to products, the cost per set-up will be:
Total set-up cost = $100,000
Total number of set-ups = 100
Cost per set-up = 100,000/100 = $1,000
Set-up cost associated with product A = 1,000 x 20 = $20,000
Set-up cost associated with product B = 1,000 x 30 = $30,000
Set-up cost associated with product C = 1,000 x 50 = $50,000
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There are 3 important factors that affect the selection of cost drivers. They are Degree of correlation, Cost of measurement, Behavioral effects.
Explanation:
A cost driver in very simple terms is the main reason of a cost, and its effect is on the total cost incurred. These cost drivers can be developed in multiple ways being "Identification of cost drivers", "Specification", "Selection of analogous systems". With these three we can develop cost drivers.
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