Cost Driver

Even after successfully reducing material costs, he would find no impact on labor costs. On the other hand, if the labor cost driver is ‘product design’, which seems logical. Complex product design may require higher manual labor while a simple design, a machine can also operate. As a result, the efforts to simplify cost driver meaning the design would show him a reduction in labor costs. To carry out a value chain analysis, ABC is a necessary tool. To carry out ABC, it is necessary that cost drivers are established for different cost pools. Find a definition, an explanation, and an analysis of cost drivers, and see helpful cost driver examples.

You can also assign driver attributes to group drivers with similar characteristics for reporting and data management purposes. Finally, the system uses pointers and implicit pointers to identify the quantitative measures on which drivers are based. Automation is essentially taking the production activity-based costing and removing the human element. This essentially makes production and equipment the same thing. The cost of operating and maintaining the equipment falls into the same bucket as production, when automated.

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Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy. A cost driver is the most appropriate way of calculating or determining a specific cost.

• It establishes the basis on which cost is to be allocated, which will ultimately result in the total cost of a product.
• Stay the same regardless of how many units you produce or sell, as long as your company keeps operating at 100%.
• 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.
• When determining the value of each activity, the business must evaluate the cost on a per unit calculation, when possible.

Many different factors can contribute to the overall cost of doing business. However, certain expenses are more significant than others, and companies need to identify and focus https://simple-accounting.org/ on these key cost drivers. It is advisable to use the most correlated cost driver for making any decisions relating to apportionment of cost, reduction of costs, etc.

How to Calculate Incremental Cost

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 ‘total cost incurred’ is its effect. If we take an example of the fuel cost of running a car, the cost driver would be ‘No. Of Kms Run’, and the total cost would be ‘total fuel cost.’ The relationship is clear, the higher the no. of km run, the higher the total cost of fuel. Of the product based on the activities performed to produce that product, which helps in finding the total cost of the product.

Some cost drivers are necessary and unchangeable while others place a high than needed overhead cost against production. These unnecessary cost drivers ultimately drive down the margins and revenue produced. Where such local alternative Cost Drivers («Local Cost Drivers») are used, they are described in the Local Term Sheet. Examining activity cost drivers helps companies to reduce unnecessary expenses and get to grips with how much an order really costs.

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When determining the cost drivers in a business, set them into distinct categories based on the activity. One common activity-based cost driver is purchasing materials. Production is impossible without the raw materials and this is an activity that will always factor into the overhead structure. Fixed costs like the yearly rent of a factory can’t have a cost driver simply because the factory rent would not increase with an increase in production, especially in the short run like a year or 2. But, if we consider a long term of 10 years, we may find some co-relation with production. In the long run, we can assume the quantity of production as a cost driver for factory rent. Fixed costs remain fixed until a range of activity, and then they shoot up to a different level.