Activity Cost DriverKnow what drives your costs up or down

Running a business isn’t just about earning revenue (though that’s the main point of it).

Anyone who owns a business will know that it comes with costs.

Do you want to purchase materials to use for the production of goods?

That comes with a cost, particularly the cost of additional materials.

Not to mention the cost of procuring said materials, as well as the cost of handling them.

How about hiring more helping hands to handle the production of goods?

That comes with a cost too.

You have to pay for the cost of their labor.

Let’s face it. Unless they’re volunteers, no one will work for no pay.

How about the space you’re using for the operations of your business?

Well, whether you own the space or not, there are still costs.

If you’re renting the space, there’s the cost of renting it.

If you own the space, there’s the cost of depreciation, as well property taxes.

There’s also the cost of maintenance and utility such as lighting, heating, and water.

These are only some of the costs that you have to prepare for when running a business.

 Along with the generation of revenue, you must strive to minimize costs as much as you can.

Having higher revenue almost always results in higher profits.

But if your costs are high enough, you won’t even be making any profit no matter the level of revenue.

If your total cost is higher than your total revenue, you’ll be generating a loss instead.

Knowing how you incur your costs will pay dividends.

If you know what causes a cost to increase or decrease, you can plan on how you can make the most out of it.

One way of knowing how you incur costs is by identifying their activity cost driver.

What is an Activity Cost Driver?

The term “activity cost driver” refers to an activity or set of activities that affect the rise or fall of business costs.

For example, the cost of sales commission increases or decreases depending on the level of sales.

In this case, the activity cost driver is the level of sales.

That said, activity costs drivers are usually linked to production or manufacturing costs such as labor costs and manufacturing overhead.

We also refer to “activity cost driver” as “causal factor”.

Activity cost drivers are usually used in managerial or cost accounting.

Particularly in activity-based costing (ABC).

An activity driver cost driver can influence relevant costs such as the cost of labor, maintenance, and other variable costs.

Identifying activity cost drivers is useful in managing costs.

By distinguishing which activities cause increases or decreases in costs, the business can become more efficient.

Understanding why costs increase or decrease helps in making the most of them.

For example, you identify that the number of labor hours mainly influences the cost of your finished goods.

Knowing this, you devise a plan that can decrease the number of labor hours needed to produce a unit of finished goods.

The following are other examples of activity cost drivers:

• Number of machine hours worked for maintenance costs
• Number of machine setups required for setup costs
• Frequency of ordering for ordering costs
• Number of product reworks for rework costs
• Number of floor or production supervisors for a portion of the cost of indirect labor
• Square footage used for the cost of rent

If you, the business owner, can identify activity costs drivers such as the examples above, you can make a more reliable and accurate estimate of the production or manufacturing costs of your business.

Activity Cost Drivers and the Allocation of Overhead Costs

Identifying your business’s activity cost drivers helps in simplifying the process of allocating overhead costs.

For example, let’s say that a machine needs maintenance after every 500 machine hours used.

The cost of this maintenance is estimated to be at $300 per instance.

Assume that you have 5 identical units of this machine.

Each machine is used to produce a certain type of product.

By knowing the number of machine hours required for the production of each product, you can allocate the cost of maintenance to each product.

Correctly allocating your manufacturing overhead costs helps in determining a more accurate cost of a product.

This is important as the cost of a product can influence its price and gross profit margin.

Be sure to choose your activity cost drivers wisely.

The Subjectivity of Activity Cost Drivers: A Limitation of Activity Cost Drivers

An inherent limitation of activity cost drivers is that they’re subjective.

It is the business’s management that identifies the activity cost drivers of production costs.

Unfortunately, there are currently no industry standards in the selection and identification of activity cost drivers.

That means that there’s an element of human error when it comes to activity cost drivers.

With that said, take caution when using activity cost drivers for the allocation of your costs.

Remember that activity cost drivers are only tools that help in the management of costs.

They are not the end all be all. Sure, they can help you in identifying and understanding which activities drive certain costs.

But activity cost drivers are not the ones running your business. You and your management are.

The Three Basic Categories of Cost Drivers

Cost drivers can be categorized into three groups:

• Volume-based
• Time-based; and
• Charge-based

Volume-based Cost Drivers

Volume-based cost drivers are those that increase or decrease costs based on the volume or number of units completed.

If the level of production increases, costs that are influenced by volume-based activity cost drivers will increase too.

A prominent example of a volume-based activity cost driver is the use of direct materials in the production of a certain product.

As the volume of production increases, so does the use of direct materials.

As such, the cost of direct materials used increases too.

For example, a single unit of product X requires at least an ounce of material A.

As you produce more units of product X, the volume of material A used in the production will increase.

Thus, the cost of direct materials, material A in this case, increases too.

Time-based Cost Drivers

Time-based cost drivers are those that increase or decrease costs based on the length of time it takes to finish an activity.

The more time it takes to complete an activity, the higher the costs influenced by time-based cost drivers will be.

An obvious example of a time-based cost drive is the number of direct labor hours.

Direct labor hours can influence the cost of several activities.

For example, the time it takes to set up a production run can be quantified using direct labor hours.

Of course, the time it takes to produce a unit of product can be quantified using direct labor hours too.

Another example of a time-based cost driver is the number of machine hours used.

For example, a machine needs maintenance every 500 machine hours used.

The number of machine hours used will determine the cost of maintenance.

The more time the machine is used, the higher the cost of maintenance will be.

Charge-based Cost Drivers

Charge-based cost drivers are used less compared to the previous types of cost drivers.

These cost drivers charge the cost of an overhead activity directly against its cost object.

The cost of depreciation is a prime example of this.

Depreciation is charged directly against its corresponding depreciable asset.