In simple terms, cost driver can be defined as the driver of cost. Just like a driver drives the car, cost driver drives the cost. Cost driver has a great relevance, especially in ABC Costing system. Cost driver analysis is the key to utilizing the concept of cost driver to its full potential. Correct cost driver determination is extremely important for effective management decision making.
What is a Cost Driver ?
A Cost Driver is that factor or variable which has a cause and effect relationship with the total cost. The cost driver is the ‘cause’ and the ‘cost incurred’ is the effect of it. If we take an example of fuel cost of running a car, the cost driver (cause) would be ‘No. of Kms Run’ and the total cost (effect) would be ‘total cost of fuel’. The relationship is quite clear. Higher the no. of km run, higher would be the total cost of fuel.
Example of Cost Drivers
There cannot be an exhaustive list of cost drivers and activities. Some of the common examples of cost drivers are as follows:
Department / Cost Centre / Cost Pool / Activity
Purchase department or Purchasing Activity
No. of Purchase Orders created.
Set Up Cost for Machine
No. of Machine Set Ups
Repairs and Maintenance of Machines
No. of Machine Hours Run
Quality Check Department or Cost
No. of Tests conducted
Cost Driver Analysis
Cost driver analysis means analyzing the various possible cost drivers for a particular type of cost or an activity etc. and explaining their cause and effect relationship between the activity and cost driver. It is advisable to use the most correlated cost driver for taking any decisions relating to apportionment of cost, reduction of costs etc. But, it should be noted that correlation is just a way to prove the relationship. Ultimately, cause and effect relationship is a must. Just for example, normally, material cost and labor cost will have a correlation. This does not mean labor cost can be a cost driver for material cost.
Advantage of Cost Drivers
A properly defined cost driver can be of great use for the managers. The precondition is the cause and effect relationship between cost drivers and their respective activity or cost center. If a manager knows with reasonable accuracy that what is driving its costs, he may focus on that reducing the quantity of that cost driver.
Suppose driver for labor cost is defined as material cost. To reduce the high cost of labor, the manager would focus on reducing the material cost where there is no cause and effect relationship. On the other hand, if the labor cost driver is defined to say product design which seems logical. A complex product design may require higher manual labor while a simple design can be operated over a machine.
Activity Cost Pool
Definition: An activity cost pool is a temporary account that is used to total the costs incurred for a specific group of activities. In other words, it’s a way to record the cumulative costs of a group of similar activities. Even though the cost pool account is similar to the factory overhead account it actually contains both fixed and variable costs. The fixed costs typically include equipment purchases; whereas, the variable costs include material and supply purchases.
What Does Activity Cost Pool Mean?
Activity cost pools are used in the managerial accounting method of activity-based costing to assigned costs to products based on their activities and production processes.
During the activity based costing process, cost accountants use activity cost pools to accumulate and total all of the costs for a specific activity. Once all of the costs have been sorted and totaled in pools, an overhead rate can be computed for the activities and eventually assigned to the products or objects based on their activity cost drivers.
Let’s take a look at an example.
Lynn’s manufacturing plant has several different departments that make vary different products. One department manufactures sunglasses and uses activity based costing to help allocate the overhead. The sunglasses department’s operations can be divided up into three main pools: design, molding, and assembly. The total costs for the department are $50,000.
Using the activity cost pools, Lynn comes up with the following cost drivers: factory square footage used, maintenance hours, machine hours, labor hours, and number of units produced. Lynn can analyze these three different pools in relation to the cost drivers and allocate the $50,000 total costs appropriately between the three pools.
As you can see, this method of assigning costs is far more accurate and helpful than estimating expenses or splitting the total costs equally amongst all three pools. Some drivers, like machine hours, don’t apply to all the pools.