What Does Activity Cost Driver Mean?

An activity 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 Cost Driver

What Does Activity Cost Driver Mean?

Activity cost drivers are associated with the managerial accounting concept of activity-based costing where job activities are divided into cost pools based on their cost driver in an effort to properly allocate indirect costs to products based on the number 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.

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. Every day 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, the number of units required to produce is one cost driver in the vehicle production process.

Why is it important?

An activity driver analysis allows the management to evaluate a company’s expenses. By pinpointing the exact source of different expenses, companies can analyze the unnecessary expenses and eliminate them. If one does not allocate cost to the factors driving activity, then the comparison between the costs of different products and services remains meaningless.

Activity cost drivers are also important in project costs. There are, however, no accounting standards for the exact calculation of cost drivers. They are only used as a tool by the management in order to understand which activities are causing certain expenses and arrive at the accurate cost of producing particular products or businesses. Cost drivers are always an estimate.

Accountants who evaluate cost drivers must possess a thorough understanding of the costs involved in the production of a particular good or service. Then they can determine an activity’s impact on the production of the product.

Examples of Activity Cost Drivers

  • Direct labor hours
  • Machine setups required
  • Number of customer contacts
  • Number of customer change orders
What Does Activity Cost Driver Mean

When to Use Activity Cost Drivers

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.

Activity cost drivers should only be used when the cost of collecting the cost driver information is less than the benefits to be gained from doing so. It makes little sense to set up a group of activity cost drivers if management does not act on the resulting information.

Activity categories

While using cost drivers to assign overhead costs to individual units works well for some activities, for some activities such as setup costs, the costs are not incurred to produce an individual unit but rather to produce a batch of the same units. For other costs, the costs incurred might be based on the number of product lines or simply because there is a manufacturing facility. To assign overhead costs more accurately, activity‐based costing assigns activities to one of four categories:

  • Unit‐level activities occur every time a service is performed or a product is made. The costs of direct materials, direct labor, and machine maintenance are examples of unit‐level activities.
  • Batch‐level activities are costs incurred every time a group (batch) of units is produced or a series of steps is performed. Purchase orders, machine setup, and quality tests are examples of batch‐level activities.
  • 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.
  • 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.

Activity-based costing vs. traditional costing 

ABC provides an alternative to traditional costing. Traditional costing applies an average overhead rate to direct production costs based on a cost driver (e.g., hours or volume). 

But, some production-related activities use more overhead expenses than others. As a result, traditional costing can give an inaccurate cost of making each product.

Traditional costing is simpler but less specific than activity-based costing. You might consider going with traditional costing if you only make a few products. 

You may also use traditional costing for reporting externally (e.g., to investors) and activity-based costing for reporting internally (e.g., to managers). 

Importance of Activity Cost Drivers

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.

Activity cost drivers are also important in project costs. For example, if management receives a sales order for a certain number of units, they can pinpoint exactly how much it is going to cost to fulfill that order.

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