What Is an Activity Cost Driver?

What Is an Activity Cost Driver?

An activity cost driver is something that drives the costs of a business. Put simply, it's anything that causes a company's variable costs to change. These drivers help companies (and their investors) understand why they spend money on certain business functions so they can make better decisions. Companies can monitor activity cost drivers to boost efficiency and company profits, price their products, and eliminate waste.

Accounting for Cost Drivers

In ABC, an activity cost driver influences the costs of labor, maintenance, or other variable costs. ABC is a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity. Multiple cost drivers may be associated with an activity. Types of cost drivers include:

• Direct labor hours: A driver of most activities in product manufacturing. If the expenditure on labor is high, this will increase the cost of producing all products or services.
• Warehousing costs: If the cost of warehousing is high, it increases the expenses incurred for product manufacturing or providing services.
• Machine hours: A technical cost driver that includes machine setups required for production.
• Engineering change orders: Costs incurred when a specification is revised.
• Machine setups: Costs required for production and the number of production inspections.

Example

When a factory machine requires periodic maintenance, the maintenance cost is allocated to the products produced by the machine. For example, the cost driver selected is machinery hours.

After every 1,000 machine hours, there is a maintenance expense of $500. Therefore, every machine hour results in a $.50 (500 ÷ 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine hours.

Using cost drivers simplifies the allocation of manufacturing overhead and helps determine the true cost of one product. Management uses the cost of a product to determine the price of the product. For this reason, the selection of accurate cost drivers directly affects an entity’s profitability and operations.

The Bottom Line

Examining activity cost drivers helps companies reduce unnecessary expenses and pinpoint the costs of an individual product or service. Businesses that can assign variable costs may develop a better pricing strategy and increase profits.