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In activity based costing (which states that products consume activities and activities consume resources) any factor which causes a change in the cost of an activity. An activity can have more than one cost driver attached to it. For example, a production activity may have the following associated cost-drivers: amachine, machine operator(s),floor space occupied, power consumed, and the quantity of waste and/or rejected output.
The cost-driver approach allocates a cost to production, based on the actions or factors that cause it. For example, the cleanup costs of a printing press might be allocated based on the number of colors used. As illustrated in the sidebar on TRADITIONAL vs. COST-DRIVER APPROACHES this results in more accurate costing.
The exhibit on Basic work phases and cost drivers shows typical cost drivers for the various stages of work (planning, getting ready to work, working, finishing and inspecting work). Examining the second stage--getting ready to work--we find activities that contribute costs to this stage include ordering raw materials and setting up machines. After accumulating applicable costs in pools, cost drivers are used to allocate these cost pools to production. Potential cost drivers for this second stage include the number of production runs or machine set-ups. If it is determined the number of production runs is the most appropriate cost driver, this pool is allocated to production in proportion to the number of production runs necessary to make the product.
Beyond better product costing and control, the tangible benefits of identifying cost drivers include:
Eliminating and reducing cost. After identifying cost drivers, the natural next step--to see if some of these costs can be eliminated or reduced--is greatly facilitated.
Highlighting cost of complexity. Maintaining an elaborate product line is costly, particularly when it results in short and numerous production runs. Usually these costs are not separated and thus are hidden. In the search for cost drivers, they will be disclosed and associated with individual products. Though marketing strategy may continue to call for having an elaborate product line, the costs will be more apparent.
Re examining long-term costs. American management and accounting practice often are criticized for focusing on the short run. The cost-driver approach, with its focus on cost causes and behavior, leads one to examine not only short-term variable production costs but also long-term costs that were considered committed or fixed. Indeed, many costs often considered fixed often do vary, however gradually, over the long term and are therefore subject to better control.
Developing management awareness. Managers can be encouraged to develop awareness of the causes of costs. Their bonuses, promotions and performance evaluations can be based on the application of cost-driver performance.
In implementing an activity-based costing (ABC) system the selection of cost drivers is a major issue since accuracy must be traded off against the complexity of the ABC-system. On the one hand, a high accuracy in allocating overhead costs often requires a high number of cost drivers. On the other hand, a small number of cost drivers is desirable to achieve acceptable information cost and to make the ABC-system easier for management to understand. In this paper a mathematical model to support optimal cost driver selection is developed. While existing approaches consider only the possible replacement of one cost driver by just one other cost driver, the model takes into account that cost drivers can also be replaced by combinations of cost drivers. This approach yields a more accurate cost allocation with the same ABC-system complexity. (2001 Academic Press)
Though a situation is considered in which ABC is able to provide precise (marginal)
costs, our model might also be helpful when this is no longer the case. For example,
when diseconomies of scale are present, proportionality between activity cost and
cost driver volume is violated and ABC tends to underestimate marginal costs.
However, one could try to compensate this effect by increasing the activity costs
of some of the available cost drivers (Christensen and Demski, 1997). Then the
most accurate ABC-system would use all available cost drivers to allocate these
systematically adjusted activity costs and the accuracy measure (6) would simply
measure the distance from this modiï¬ed benchmark system.
According to experts, the underlying criteria for selecting cost drivers are
optional though they are still very important. They are:
1. Easy identification, use and understanding. To easily identify a cost
driver we must investigate its relationship with indirect costs. After identifying
all work activities (typically in an "activity dictionary"), a cost assignment
model is constructed that contains complete information about the origin of
resource expenses and their cost allocation methods. 10 Gary Cokins, Sorinel CÄƒpuÅŸneanu
2. The existence of a direct relationship between indirect costs and cost
drivers. Starting from the correct identification of cost drivers that highlight the
causal connections between indirect costs and cost drivers, this then allows for
obtaining accurate and true actual costs of cost objects (e.g., activities, products,
3. Positive or negative influence on staff. Explaining the concept of a cost
driver to managers and employees creates the advantages for better
understanding of the behavior of costs and what influences changes in them.
This leads to an inner harmony within the enterprise between employees and
management, thereby increasing business performances by providing visibility
as to what factors drive the consumption of costs. For commercial companies it
accurately reports layers of profit margins for analysis and actions.
According to experts, the criteria for determining and selecting cost
drivers are particularly important.