Demystifying the concept of Cost Drivers in Activity-Based Costing (ABC)

Summary

• Cost drivers are actions that cause costs to increase or decrease.
• Cost drivers are used in activity Based Costing (ABC).
• Allocating cost drivers appropriately is important in accurately determining the cost of producing a good or service, as well as making financial budgets, forecasts & projections.
• ?The concept of cost drivers in Activity-Based Costing (ABC) is central to accurately assigning costs to products, services, or activities based on the actual resources consumed.

What are Cost Drivers?

• Cost drivers are factors that cause changes in the cost of an activity. They are the basis for assigning costs to cost objects (such as products, services, or customers) in ABC. Essentially, cost drivers link the consumption of resources to specific activities and ultimately to the cost objects.
• Cost driver refers to actions that cause variable costs to increase or decrease for a business. Therefore, identifying what product/service is causing particular costs can help the business to become more profitable by better understanding the specific activities that are driving the costs.

Activity-based costing (ABC) in short:

• Activity-based costing (ABC) is a costing method where indirect costs are assigned to products and services. It is done by looking at which products demand particular costs. For example, under ABC, a manufacturing company may decide to allocate rent expense to each product based on the amount of space the machines that are utilized to produce that particular product uses. Improperly allocating the costs can result in poor decision-making.
• Imagine that the manufacturing plant produced two items with the exact same price and sales volume. The direct costs for Item A and Item B are Rs.1,000 per month and Rs.500 per month, respectively. However, Item A used up 10% of the manufacturing space, while item B used up 90%. If rent is Rs.1,000 per month, the total rent allocated to item B would be Rs.900 and Rs.100 to item A). Therefore, the total cost to produce item A is Rs.1,100, and the total cost to produce item B is Rs.1,400. While the above is a very simplified example compared to a real-world situation, it shows the importance of allocating indirect costs to get a more accurate costing & therefore financial picture of a company.

Types of Cost Drivers

Cost drivers in ABC can be broadly classified into the following categories:

1. Transaction Drivers:

?? - These are related to the number of times an activity is performed.

?? - Example: Number of purchase orders processed, number of machine setups required, number of quality inspections conducted.

2. Duration Drivers:

?? - These are related to the amount of time required to perform an activity.

?? - Example: Hours of machine operation, hours of setup time, hours of inspection time.

3. Intensity Drivers:

?? -These are related to the intensity of resource usage.

?? - Example: The cost of materials used, the amount of electricity consumed, the volume of goods handled.

Identifying Cost Drivers:

1. Identify Activities:

?? - Determine all the significant activities involved in the production of goods or services.

?? - Activities can include procurement, warehousing, manufacturing, Quality assurance, R &D, packaging, shipping, customer service, etc.

2. Analyse Resource Usage:

?? - Understand how resources are consumed by these activities.

?? - Determine the factors that influence the cost of each activity.

3. Select Appropriate Cost Drivers:

?? - Choose cost drivers that accurately reflect the consumption of resources for each activity.

?? - Ensure that the chosen drivers are measurable and directly linked to the activities.

Examples of Cost Drivers

- Manufacturing: Number of machine hours, number of setups, number of quality inspections.

- Distribution: Number of shipments, weight of goods shipped, distance travelled.

- Customer Service: Number of service calls, hours of service provided, number of customer complaints resolved.

• - Administration: Number of invoices processed, number of payroll transactions.

Practical View:

• Imagine that A machining operations Automotive parts making unit needs to clean, lubricate & recalibrate a machine after every 2000 pieces are manufactured. In this case, the cost driver would be the number of parts produced. The cost of cleaning, lubricate & recalibrate the machine is Rs.5000.

• Therefore, every piece produced results in Rs.2.50 (5000 / 2000 pieces) of cost allocated. The activity cost driver would be used in conjunction with others in determining the margin that operation is making on this part.

Benefits of Using Cost Drivers in ABC

1. Accuracy:

?? - Provides a more accurate allocation of overhead costs to products or services based on actual resource consumption.

?? - Helps in identifying high-cost activities and managing them more effectively.

2. Cost Control:

?? - Enables better cost control by linking costs directly to activities.

?? - Helps in identifying inefficiencies and areas where cost savings can be achieved.

3. Improved Decision Making:

?? - Provides detailed insights into the cost structure & break up, helping managers make informed decisions about pricing, product mix, process improvements, and even outsourcing. It is easier & better to benchmark with other industries.

4. Enhanced Performance Measurement:

?? - Facilitates performance measurement by linking costs to specific activities and their drivers and providing a clearer picture on the costs.

?? - Helps in setting more accurate product cost system, budgets and performance benchmarks, KPIs.

Implementing Cost Drivers in ABC

1. Activity Identification:

?? - Break down the production or service delivery process into distinct activities. This should be keeping in mind the utility y of the activity to be identified separately. The simpler & less is the better as far as practical application is concerned.

2. Cost Driver Selection:

?? - Choose the most appropriate cost driver for each activity, keeping the practical aspects like measurability in mind.

3. Data Collection:

?? - Collect data on the selected cost drivers. This could involve tracking the number of transactions, hours worked, quantities processed, etc. keeping in mind the flow chart of entire operation or plant & layouts.

4. Cost Allocation:

?? - Allocate overhead costs to products or services based on the usage of the cost drivers. in large operations, generally an ERP system shall be used.

5. Analysis and Reporting:

?? - Analyse the allocated costs and use the information for decision-making and performance improvement. This activity should be performed on continuous basis on the PDCA principles.

Challenges

1.???? Data Collection: There are only accounting principles for guidance & no exact accounting standards for how activity cost drivers should be identified & allocated in a particular industry. When done in close cooperation with production or service departments, they are used as a tool to help management understand which activities are driving certain expenses and the true cost of producing particular products or services.

2.???? ?Especially with larger and more complex businesses, cost drivers will always be a very good estimate of the cost with high accuracy as compared to other tools.

3.???? Accountants who estimate cost drivers must possess a thorough understanding of what goes into the production of a particular good or service & entire production cycle. They then determine a particular activity’s impact on the production of that product, keeping in mind the machine running, shifts usage, material losses like burning loss in cutting & melting, overtime, utility usage, tools & dies usage, consumables usage, wastage, scrap generated in process like turning, bye-products & related recoveries.

4.???? Gathering accurate and detailed data on cost drivers can be time-consuming and challenging and that is why for large databases, Erps or specific tools are used.

5.???? ?The process can become complex, especially in large organizations with numerous activities and cost drivers, so due care has to be taken while design.

6.???? ?Implementing ABC and tracking cost drivers can be expensive, cost intensive on a recurring basis, requiring investment in systems and training.

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Conclusion:

• By understanding and effectively using cost drivers in Activity-Based Costing, organizations can achieve a more accurate and meaningful allocation of costs, leading to better cost management and strategic decision-making.
• Looking through the lenses of cost drivers, management can better understand a company’s costs & expenses. By determining the exact source of different costs, companies can be helped to reduce or eliminate unnecessary costs. Without proper allocation of the cost drivers, it can be meaningless to compare the costs of different products and services.
• Activity cost drivers are also important in projecting costs & making competitive quotes to prospective customers. For example, if management receives a sales order for a certain number of units, they can point exactly how much it is going to cost to fulfil that order.