When it comes to running a business, there are countless factors to consider. One of the most important and often overlooked aspects of business management is cost drivers. Cost drivers are an important component of your business model and can influence many different aspects of your business. Cost drivers are the factors that affect the cost of goods or services that you produce, and thus affect your overall profitability. Understanding cost drivers and how they can influence your business can provide the insights needed to create a successful business model and maximize your profits. In this blog post, we’ll discuss the importance of cost drivers and how to use them to your advantage. We’ll provide an overview of what cost drivers are, how they affect your costs, and the different types of cost drivers. We’ll also offer advice on how to identify and leverage cost drivers to your advantage. By the end of this post, you’ll have a better understanding of cost drivers, how they affect your business, and how
Why are cost drivers important?
To keep a company’s finances in order and forecast future profits, cost drivers are crucial. Businesses can make sure that their cost of production does not exceed their revenue by analyzing cost drivers.
Businesses can determine their total production costs by factoring in cost drivers, and then use this number to set product prices. For instance, if it costs $200 to produce 100 T-shirts, the seller may decide to charge $6 for each shirt. This would generate sales of $600 for all the shirts and net the business a profit of $400.
What are cost drivers?
Cost drivers are the direct cause of a business expense. Any action that results in the cost of another thing is a cost driver. An illustration of this might be how the cost of your water bill is determined by how much water your office uses each month. The cost factors are the water units, and the cost is the water bill. This idea shows that all activities involve the use of resources, and that each activity that people perform has a corresponding resource cost.
Direct v. indirect costs
Anything that directly or indirectly affects the cost of business activity is a cost driver. The following are some distinctions between direct and indirect costs:
Direct costs
A direct cost is an expense that you directly link to a particular good or service. Materials required for production and labor costs are two typical examples of direct costs in a business. Direct costs are typically regarded as variable costs because they are based on the anticipated number of units the company will produce. In contrast, since employee salaries typically do not rise or fall in tandem with production rates, they are regarded as fixed costs rather than variables.
Indirect costs
An indirect cost is a charge that is separate from the direct expenses incurred during production. Anything that does not directly relate to producing a product can be considered an indirect cost, including business utilities, office supplies, marketing, employee benefits, human resources, and insurance. Like their direct counterparts, indirect costs can be either fixed or variable. Electricity is an illustration of a variable indirect cost because its cost can change. Rent for a company’s facilities is a fixed indirect cost because it frequently remains constant for a long time.
What is activity-based costing?
Another crucial component of activity-based costing (ABC) is cost drivers. Professionals use activity-based costing to determine how much a company spends on each product in direct and indirect costs. Activity-based costing, also known as overhead, allocates the costs of resources required for the business activity to take place, allowing companies to determine the true cost of their products. Activity-based costing systems are frequently used in workplaces with machinery and concurrent production processes.
A shoe manufacturer with a $20,000 annual electricity bill for their warehouse is an example of activity-based costing. The annual total of 2,000 hours of operation is what drives the cost of the electricity bill. The business is left with a cost driver rate of $10 per hour after dividing the $20,000 cost by the 2,000 cost driver hours. The business needs five hours of electricity to produce a pair of shoes. The business can now determine through the use of ABC that the overhead electricity costs for producing a pair of shoes are $50.
Cost driver examples
Here are some common examples of cost drivers:
Number of labor hours
One of the most typical types of cost drivers is the number of hours that employees work for a company. This determines the wages that the company pays its employees. Additionally, it is directly related to how much is produced during the designated working hours. Typically, more working hours results in a higher product yield.
Number of customers
A companys clientele helps determine its profits. A company can sell more products and generate more revenue if it has more customers. One of the most important cost drivers for developing a company’s business model is this one. The volume of sales determines the production rate, and rising demand necessitates rising supply.
Machinery operation hours
The amount of time businesses spend operating machinery is a significant cost driver for industries that depend on it to produce their goods. It’s wise to take into account how long the machines run since this directly affects how much electricity and other resources they consume. Utilizing machines more effectively due to the tracking of time and resources may lower production costs.
Number of returned products
Returns are a cost factor because they result in a loss for the business when a customer receives a refund. A return also accounts for any production, manufacturing, and delivery expenses that a final sale did not cover. By ensuring product quality, you can reduce customer returns and increase sales for your business.
What are Cost Drivers? (Cost Accounting Tutorial #2)
FAQ
What is an example of a cost driver?
Direct labor hours worked, customer contacts made, engineering change orders issued, machine hours used, and the number of product returns from customers are a few examples of cost drivers.
What is the meaning of cost drivers?
The direct cause of a cost is known as a cost driver, and it has an impact on the overall cost incurred. For instance, the number of units consumed determines the total electricity bill if you need to calculate how much electricity was used during a specific time period.
What are the types of cost drivers?
There are three different categories of cost factors: volume, unit price, and fixed costs (overhead).
