Activity Cost Driver Overview, How It Works, Example

Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process. Banta’s time-driven ABC system, which was fully implemented within 16 weeks, revealed much more granularity in its expense structure by tying costs to products, orders, customers, and territories. With the time-driven approach, Hunter’s ABC team of analysts was able to group the three activities into a single departmental process, called inside sales order entry. The team learned that it took about 5 minutes to enter the basic order information, plus 3 minutes for each line item, and an additional 10 minutes if the order had to be expedited.

Cost drivers are most often used to allocate overhead costs to different products. Here, the cost for an entire overhead activity goes directly against the cost object. For example, equipment depreciation goes to the end product in a production activity.

Example of an Activity Cost Driver

Note that these rates are lower than those estimated using traditional ABC methods (see again the exhibit “Doing ABC the Traditional Way”). The reason for this difference becomes obvious when we recalculate the quarterly cost of performing the customer service activities. This takes care of the technical drawback of traditional ABC systems we mentioned earlier—the fact that surveyed employees respond as if their practical capacity were always fully utilized.

Either one uses the amount of hours spent in a certain activity to be the cost allocation basis for overhead costs. In the case of our customer service department, the traditional ABC survey produced a work distribution of 70%, 10%, and 20% of the employees’ time performing the department’s three activities. But while that distribution did reflect how workers spent their productive time, the fact that their total productive time was significantly less than their practical capacity of 32 hours per worker per week was completely ignored. Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method.

Analysis of Cost Drivers

There are no accounting standards for how activity cost drivers should be allocated. They are only used as a tool to help management understand which activities are driving certain expenses and the true cost of producing particular products or services. Especially with larger and more complex businesses, cost drivers will always be an estimate.

For example, if the customer service department gets a new database system, the reps may be able to perform a standard credit check in 20 minutes rather than 50 minutes. To accommodate the improvement, just change the unit time estimate to 20 minutes, and the new cost-driver rate automatically becomes $16 per credit check (down from $40). Of course, https://kelleysbookkeeping.com/section-179-tax-deduction-for-2021/ you then have to add back in the cost impact of purchasing the new database system by updating the cost per time unit estimate, so the final figure may be somewhat higher than $16. Let’s say employees report that they spend (or expect to spend) about 70% of their time on customer orders, 10% on inquiries or complaints, and 20% on credit checks.

AccountingTools

Cost drivers can be either unit-level, batch-level, organizational-level, or product-level, depending on how they relate to the activity. Examples of cost drivers include the number of labor hours, the number of units produced, the number of machine hours, the number of batches, or the square footage of a facility. Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. Doing this helps to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy and churn out higher profits.

In the revised approach, managers directly estimate the resource demands imposed by each transaction, product, or customer. Traditional ABC models also often fail to capture the complexity Activity Cost Driver of actual operations. In addition, the order may be entered into the system either manually or electronically, and it may be either a standard or an expedited transaction.