Activity Cost Driver

What is Activity Cost Driver?

An activity cost driver, also called a casual factor, is an element that causes the cost of an activity to increase or decrease. In other words, it’s a factor associated with a production process or activity that can cause volatility in the cost of production or activity time.

An activity cost driver is an accounting term. A cost driver affects the cost of a specific business activity. In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.

What Does Activity Cost Driver Mean?

Activity based costing is an approach that assigns costs to products or services based on the activities and corresponding resources that go into them. Activity Cost Driver establishes the relationship between activity and the cost.

Activity-based costing (ABC) is a more accurate way of allocating both direct and indirect costs. ABC calculates the true cost of each product by identifying the amount of resources consumed by a business activity, such as electricity or man hours.

Activity cost drivers are associated with the managerial accounting concept of activity based costing where job activities are divided in to cost pools based on their cost driver in an effort to properly allocate indirect costs to products based on the amount of activities required to produce them. The cost driver can be anything in the pool that causes the cost of the activities to increase or decrease.

An activity cost driver is an action that triggers the incurrence of a cost. A cost driver causes variable expenses to be incurred. There may be more than one activity cost driver that initiates the incurrence of a variable expense. When a management team has a comprehensive knowledge of activity cost drivers, it can make better decisions that enhance the profitability of an organization. Activity cost drivers are not required in the formulation of financial accounting information. Instead, they are used in management information systems.

How Activity Cost Drivers Work?

A cost driver directly influences a business activity. There may be multiple cost drivers associated with an activity. For example, direct labor hours are a driver of most activities in product manufacturing. If the cost of labor is high, this will increase the cost of producing all company products or services. If the cost of warehousing is high, this will also increase the expenses incurred for product manufacturing or providing services.

More technical cost drivers are machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.

Example

An example of an activity cost driver in a manufacturing plant is the number of orders that must be produced. Take the Ford plant for example. Everyday thousands of cars are ordered into the production line by management. Each department from painting to assembly has a set amount of cars that must be completed each day. If this number changed, the cost of production would also change.

Increased levels of production would require more paint, more parts, and more workforce labor time to assemble. The opposite is true if production decreased. Thus, number of units required to produce is one cost driver in the vehicle production process.

Since “production” is a very large cost pool, it would most likely be split into smaller cost pools in a real system. For instance, the painting process would be split into its own cost pool including activities like bodywork, sanding, buffing, and spraying. A cost driver for the painting department might be the increased wages in accordance with the new union agreement. Since preparing car bodies is a fairly labor intensive operation, an increase in wages can drastically increase the cost of the activity.

Speps of Activity Based Costing

Activity Based Costing involves following steps.

  • Identification of activities involved in the production process;
  • Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level, product level and facility level);
  • Identification and accumulation of total costs of each activity;
  • Identification of the most appropriate cost driver for each activity;
  • Calculation of total units of the cost driver relevant to each activity;
  • Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver;
  • Application of the cost of each activity to products based on its activity usage by the product.

Summary

  • Activity-based costing (ABC) is an accounting method that allocates both direct and indirect costs to business activities.
  • A cost driver simplifies the allocation of manufacturing overheads, such as the costs of factory space and electricity.
  • Management selects cost drivers based on the associated variables of the expense incurred.