Cost Drivers

A cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments. The cost is allocated based on the driver's activity completed in that particular period. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity.

They are an essential source for allocating the costs  of the product based on the activities performed to produce that product, which helps in finding the total cost of the product. The total cost of the product helps the management analyze the decision to produce the product and determine the selling price of the product, which the customers will accept and be ready to pay.

The cost driver is that variable or factor which has an effect and causes the relationship with the total cost. It is the cause and the cost incurred in its effect. Its analysis means identifying all the possible cost drivers for a particular type of activity or cost etc., and explains their cause and effect relationship with the event. It should be understood that correlation is just a way to prove the relationship.

It is important to understand and identify these cost drivers in cost accounting so aa sto get a better understanding about the business and the factors affecting its cost, which will help in making informed business decisions related to pricing, revenue, sales targets, optimization of the overall business process and also individual departments, allocation of resources in a cost effective manner, to ensure best utilization with minimum wastage, etc.

The cost drivers accounting helps business improve efficiency of the entire business process, expense management and a considerable rate of growth and expansion in the competitive environment.

There are many types of cost drivers in cost accounting. As per traditional accounting, the manufacturing and indirect costs are allocated on the predefined rate based on the activity performed.

1. Numbers of Set-Ups
2. Number of Machine Hours
3. Number of Processed Orders
4. Number of Orders Completed
5. Number of Labor Hours
6. Number of Deliveries
7. Number of Calls Taken
8. Number of Rides

These are not just the only types, but there may be many other types of cost drivers based on the type of activity being performed and the basis of division of that activity in terms of cost to be allocated to various departments.

Let us understand the concept of cost drivers accounting with the help of a suitable example.

Following is the cost structure of XYC Inc. Please allocate the following costs based on the cost drivers.

Solution:

Allocation of cost on the basis for XYZ Inc:

Calculate Total of the Costs

The above example helps us to understand how to identify the various types of costs in the accounts or financial statements of a business and use them to analyse the cost drivers and ultimately calculate the cost incurred in a particular operation of department. This is useful in evaluating whether the cost is within estimated limits or requires some control measures to ensure that the overall profitability is not affected.

This system of cost drivers in cost accounting is basically to compute the product cost. In business, it is vital to find the cost of the product, to identify whether the business can make the required profits from producing those products. If the cost is higher than the revenue generated from the product sale, it will benefit the business. In contrast, if the costs are higher than the revenue generated, the business would have to rethink the decision to go for the production. Now in defining the product cost, these cost drivers play an essential role. It establishes the basis on which cost is to be allocated, which will ultimately result in the total cost of a product.

• As mentioned above in the application of cost drivers in business, it is evident to know the cost of the product before entering the market to pre-identify whether the company can make profits out of the products they propose to sell.
• This application is essential to identify the cost allocable to various products as the cost is allocated based on the activities performed. Only those costs should be assigned to a product that includes a particular activity in its production.
• The cost drivers in business makes that allocation possible, and only then the real cost of the product being manufactured will be determined. Then the management would decide whether to enter the market or not and whether to produce the product.

Some advantages of the process of cost drivers of globalisation are as given below:

1. It provides a competitive edge to the business as they give a precise distribution of cost based on activities performed.
2. These are an advantage for a product as they bring out the actual cost incurred on the products based on the correct allocation of the processes or activities.
3. It improves the relationship between the departments, as there are many common activities and processes which are performed for in various department.
4. It helps management see a business's various departments as one single business unit as these drivers create a relationship between the departments.

The following are some of the disadvantages of the financial concept of cost drivers of globalisation.

1. It is a complex process, and not every business can apply the cost drivers in its activities.
2. It is hard to determine the exact basis for the cost drivers to get the actual costs, which will defeat the ultimate goal of the business to find the actual cost of the product.
3. Cost drives application requires a thorough understanding of the cost functions. Otherwise, it would either be a selection of the wrong basis of allocation or an incorrect selection of process.

It is important to understand the pros and cons of ths concept so that it can be applied and used in appropriate areas for maximum positive results in terms of output, growth and efficiency.

• Cost Object is the product’s, process, department, or customer-related management term, defining the costs originated from or is associated with. A cost object can be identified with a product, process, department, or customer and tracked back to why the cost was incurred.
• This is the basis on which the cost incurred can be allocated to the product, department, process, or customer. The difference is why the cost was incurred and on what basis to allocate the incurred cost. It is the two phases of a single chain of production

This article has been a guide to Cost Drivers & its definition. We explain with example, types, importance, advantage, disadvantage & differences with cost object. You can learn more about it from the following articles –

• What is Appraisal Costs?
• Incurred Cost
• What are Indirect Expenses?
• Cost Basis Example