What Is A Activity Cost Driver?

By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles. Activity-based costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had realized. 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. Using the plantwide allocation method, calculate the predetermined overhead rate and determine the overhead cost per unit for the inkjet and laser products.

The cost information provided by ABC is generally regarded as more accurate than the information provided by most traditional costing methods. This allows management to make better decisions in areas such as product pricing, product line changes , and product mix decisions . In order to make a profit on their products, these companies must accurately determine how much it costs to manufacture each product.

Distribution Of Overhead Costs

Note that the report highlights the difference between capacity supplied and the capacity used. Managers can review the cost of the unused capacity and contemplate actions to determine whether and how to reduce the costs of supplying unused resources in subsequent periods; they can then monitor those actions over time. In some cases, the information can save companies that are considering expansion from making unnecessary new investments in capacity. For example, the vice president of operations at Lewis-Goetz, a hose and belt fabricator based in Pittsburgh, saw from his time-driven ABC model that one of his plants was operating at only 27% of capacity. Rather than attempt to downsize the plant, he decided to maintain the capacity for a large contract he expected to win later that year, for which he otherwise would have created new capacity. Such expansion has caused ABC systems to exceed the capacity of generic spreadsheet tools, such as Microsoft Excel, and even many ABC software packages.

In addition, approximate the relationship between costs and cost drivers using regression analysis. 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 an ABC system, you can assign costs to each activity in the production process. This shows you all the costs that go into producing a specific product. You can use this data to set a price that more accurately accounts for how much it costs you to create the product.

What Is A Activity Cost Driver?

Product costing is the process where businesses determine the expenses required for manufacturing a product. Learn the details of traditions vs activity-based costing, and the formula demonstrated in a set of examples. Kemps, headquartered in Minneapolis, is a full-line dairy, that produces milk, yogurt, sour cream, cottage cheese, and ice cream products. Its customers are retailers and distributors as large as SuperValu and Target and as small as convenience stores.

Activity-based costing allows for more accurate product costing than other types of costing method because it requires the calculation of multiple rates to allocate manufacturing overhead to products. Activity cost pools are an important part of activity-based costing as they enable companies to group similar overhead costs together and divide by a common cost driver. This enables the companies to have multiple criteria for allocating overhead instead of just one like in traditional costing systems. Manufacturing companies use product costing techniques to determine how much it costs to manufacture each product it produces. Activity-based costing systems allocate manufacturing overhead by assigning indirect costs to activity cost pools, then dividing each cost pool by a cost driver to obtain the rates used for allocation. Manufacturing overhead costs are the expenses incurred in the manufacture of a product that cannot be directly allocated to that product. Activity cost pools are groups of individual costs influenced by the same cost drivers , which are activities that control the amount of costs incurred.

Activity

At a rate of $30 per machine hour, the Deluxe boat is assigned $1,200 per boat for this activity ($30 rate × 40 machine hours) while the Basic boat is assigned $300 per boat ($30 rate × 10 machine hours). The ABC column represents overhead costs allocated using the activity-based costing shown back in Figure 3.5 “Allocation of Overhead Costs to Products at SailRite Company”. As you can see in Figure 3.6 “SailRite Company Product Costs Using Activity-Based Costing”, overhead is a significant component of total product costs. This explains the need for a refined overhead allocation system such as activity-based costing. This information is needed to calculate the product cost for each unit of product, which we discuss next.

• Comment on the differences between the results of the two approaches.
• 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.
• The capacity of most resources is measured in terms of time availability, but the new ABC approach can also recognize resources whose capacity is measured in other units.
• 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.
• Try it now It only takes a few minutes to setup and you can cancel any time.
• And assigning costs to products requires a significant amount of time in the accounting department.

Traditional costing applies an average overhead rate to direct production costs based on a cost driver (e.g., hours or volume). Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product.

Business In Action 3 2

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, 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. In using activity-based costing, the company identified four activities that were important cost drivers and a cost driver used to allocate overhead. These activities were purchasing materials, setting up machines when a new product was started, inspecting products, and operating machines. Looking at activity cost drivers can allow management to better understand a company’s expenses. By delineating the exact source of different expenses, companies can help to reduce or eliminate unnecessary expenses. Without proper allocation of the cost drivers, it can be meaningless to compare the costs of different products and services.

• In the table below, we present several examples of the cost drivers companies use.
• For our customer service department, we obtain cost-driver rates of $6.40 (8 multiplied by $0.80) for processing customer orders, $35.20 (44 by $0.80) for handling inquiries, and $40 (50 by $0.80) for performing credit checks.
• By updating the ABC model on the basis of events rather than on the calendar , you get a much more accurate reflection of current conditions.
• With an ABC system, you can assign costs to each activity in the production process.

The management of Parker Company would like to use activity-based costing to allocate overhead rather than use one plantwide rate based on direct labor hours. The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs. Labor and materials costs are considered direct costs if they are incurred during the manufacture of a product and can be directly allocated to that product. Manufacturing overhead includes all other expenses incurred during the manufacture of a product that cannot be directly allocated to that product.

See For Yourself How Easy Our Accounting Software Is To Use!

As an example to calculate the per unit cost for the purchasing department, the total costs of the purchasing department are divided by the number of purchase orders. Once the per unit costs are all calculated, they are added together, and the total cost per unit is multiplied by the number of units to assign the overhead costs to the units. Look at the overhead rates computed for the four activities in the table below.

The problem with this approach is that fixed costs are often a large part of the overhead costs being allocated (e.g., building and machinery depreciation and supervisor salaries). Recall that fixed costs are costs that do not change in total with changes in activity. Payroll taxes and fringe benefits are driven by direct labor hours and will be included in one cost pool. Factory maintenance and factory rent are driven by the number of square feet used per widget and will be included in another cost pool. Purchasing labor and supplies are driven by the number of purchase orders and will be included in yet another cost pool.

In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. A cost driver rate is the amount of indirect or variable cost assigned to each unit of cost driver activity. For example, you may apply indirect overheadto direct labor hours as $50 dollars per hour. In this case, for each hour of direct labor required for production, the company would then allocate $50 of indirect overhead costs to the production activities or output. Traditionally, in a job order cost system and process cost system, overhead is allocated to a job or function based on direct labor hours, machine hours, or direct labor dollars. In such companies, activity‐based costing is used to allocate overhead costs to jobs or functions.

Your employees might miscalculate or even exaggerate their time spent working on an activity. Product‐line activities are those activities that support an entire product line but not necessarily each individual unit. Examples of product‐line activities are engineering changes made in the assembly line, product design changes, and warehousing and storage costs for each product line. Imagine that McDonald’s needs to clean their ice cream machine after every 200 ice cream cones sold. In this instance, the cost driver would be the number of ice cream cones produced. (See the exhibit “Profitable Decisions at Banta Foods.”) Its performance has led to the distinction of being named “Innovator of the Year” by the industry journal, Institutional Distributor.

You might consider going with traditional costing if you only make a few products. Facility support activities are necessary for development and production to take place. These costs are administrative in nature and include building depreciation, property taxes, plant security, insurance, accounting, outside landscape and maintenance, and plant management’s and support staff’s salaries.

Once the drivers are determined, the expenses are grouped by common cost drivers to create the activity cost pools specific to that company’s production. Activity cost drivers are specific activities that cause variable expenses to be incurred. One variable expense can comprise more than a single activity cost driver. For example, machine hours and labor hours can be activity cost drivers in the manufacturing of a product. Product costing involves allocating costs from activity centers to products and calculating a product cost per unit.

Allocating cost drivers appropriately is important in accurately determining the cost of producing a good or service, as well as making financial projections. Cost accounting is a form of managerial accounting that aims to capture a company’s total cost of production by assessing its variable and fixed costs. Calculate the per unit profit for each product using the plantwide approach and the activity-based costing approach. Comment on the differences between the results of the two approaches.

The cost-driver rates can now be calculated by multiplying the two input variables we have just estimated. For our customer service department, we obtain cost-driver rates of $6.40 (8 multiplied by $0.80) for processing customer orders, $35.20 (44 by $0.80) for handling inquiries, and $40 (50 by $0.80) for performing credit checks. Once you have calculated these standard rates, you can apply them in real time to assign costs to individual customers as transactions occur. The standard cost rates can also be used in discussions with customers about the pricing of new business.

And, finally, electricity and equipment depreciation are driven by machine hours and will be included in the final cost pool. The second factor that can cause a change in the activity cost-driver rate is a shift in the efficiency of the activity. Quality programs, continuous improvement efforts, reengineering, or the introduction of new technology can enable the same activity to be done in less time or with fewer resources.

The point here is that managers must beware of using per unit cost information blindly for decision making, particularly if a significant change in the level of production is anticipated. An activity-based costing rate is calculated by assigning indirect costs to a cost pool, adding the costs included in that cost pool together, then dividing the cost pool total by the cost driver.

Abc In Action At Sailrite Company

Kemps markets its products under its own branded portfolio along with products sold through private label and copacking contracts. Like most dairies, Kemps was experiencing consolidation in its customer base. It decided to shift from its former customer relationship strategy—willing to do whatever the customer asked—to a lower-total-cost strategy. The new approach clearly required an accurate understanding of cost by product and customer that Jim Green, Kemp’s CEO, would use to instill a “low total cost” culture throughout the organization. Let’s say you allocate $10,000 in overhead to setting up 4,000 machines .

Some costs that cannot be linked to products based on causality or benefits received are assigned on the basis of reasonableness. Choose a cost driver so costs are assigned in proportion to benefits received. For example, if the physics department in a university benefits more from the university’s supercomputer than the German department does, the university should select a cost driver that recognizes such differences in benefits.

Managerial Accounting

Let’s say employees report that they spend about 70% of their time on customer orders, 10% on inquiries or complaints, and 20% on credit checks. Accountants estimated the overhead and the volume of events for each activity. For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000. Finally, running machines would cost $600,000 for 20,000 machine hours.