Cost Driver

COST DRIVERS

&

COST BEHAVIOUR

Dr. Rana Singh

www.ranasingh.org

COST DRIVER - DEFINITION

An activity which generates cost

A factor such as the level of activity or volume

that causally affects cost.

Existence of a cause-and-effect relationship

between a change in the level of activity or

volume and change in the level of total costs of

that cost object.

Thus cost drivers signify factors, forces or

events that determine the costs of activities

COST DRIVER - IDENTIFIED

Direct costs do not need cost drivers

They are themselves cost drivers since they can

be traced directly to a product.

All other factory or manufacturing costs need

cost drivers.

COST DRIVERS – WHY?

They are the links between a pool of costs in an

activity centre and the product

Therefore in order to trace overhead costs to

products, appropriate cost drivers should be

identified.

A pool of costs

COST DRIVERS

Product

COST DRIVER - TYPES

There are two categories of cost driver:

Resource Cost Driver: A measure of the

quantity of resources consumed by an activity.

Used to assign the cost of a resource to an

activity or cost pool.

Activity Cost Driver: Measure of the frequency

and intensity of demand, placed on activities by

cost objects. Used to assign activity costs to cost

objects.

ACTIVITIES & COST DRIVERSFUNCTIONAL

AREAS

ACTIVITIES SUITABLE COST

DRIVERS

Materials

Management

• Issue of purchase orders • Number of purchase orders

• Inspection of materials • Number of purchase orders

Stores

Management

• Storing of materials • Value of materials stored

• Servicing of requisitions • Number of requisitions

• Inspection & Verification • Number of times inspected

• Stock Taking • Value of stock

Quality Control • Testing of Samples • Number of batches produced

Marketing • Demand Creation • Increase in sales

• Advertising • Increase in sales

• Despatches •Number of orders

ACTIVITIES & COST DRIVERSFUNCTIONAL

AREAS

ACTIVITIES SUITABLE COST

DRIVERS

Personnel

Management

• Recruitment of

employees

• Number of employees

recruited

• Maintenance of leave

records & attendance

• Number of employees

Research &

Development

• Research • Number of research Projects

Machining • Setup Cost • Number of production runs

• Power cost •Machine hours

ACTIVITIES-CLASSIFICATION

In manufacturing organizations, activities are

grouped on the basis of different levels at which

activities are performed and hence are identified

and classified into broadly four different

categories: Unit Level

Activities

Batch Level

Activities

Product Level

Activities

Facility Level

Activities

UNIT LEVEL ACTIVITIES

Activities performed each time a unit is

produced.

They are repetitive activities

Example: Direct labour hours, Machine hours,

Power are used each time a unit is produced

Costs of unit level activities vary with the

number of units produced

BATCH LEVEL ACTIVITIES

Activities performed each time a batch of goods

or products is produced

Costs of batch level activities vary with the

number of batches but are fixed with respect to

the number of units in each batch

Example: Machine setups, inspections,

production scheduling, materials handling

PRODUCT LEVEL ACTIVITIES

Activities performed to support the production

of each different type of product

Example: Maintenance of equipment,

engineering charges, testing routines,

maintaining bills of materials

FACILITY LEVEL ACTIVITIES

Activities needed to sustain a factory’s general

manufacturing process

These are common to a variety of products

Most difficult to link to product specific

activities

Examples: Factory management, maintenance,

security, plant depreciation

EXAMPLES

Examples of costs driven by activities at each level:ACTIVITY LEVEL EXAMPLES OF ACTIVITY COST

1. Unit Level • Cost of raw materials

• Cost of inserting a component

• Utilities cost of operating equipment

• Some costs of packaging

• Sales Commissions

2. Batch Level • Cost of processing sales order

• Cost of issuing and tracking work order

• Cost of equipment setup

• Cost of moving batch between workstations

• Cost of inspection (assuming same number of units

inspected in each batch)

EXAMPLES…

ACTIVITY LEVEL EXAMPLES OF ACTIVITY COST

3. Product Level • Cost of Product Development

• Cost of Product marketing such as advertising

• Cost of specialized equipment

• Cost of maintaining specialized equipment

4. Facility Level • Cost of maintaining general facilities such as buildings

and grounds

• Cost of non-specialized equipment

• Cost of maintaining non-specialized equipment

• Cost of real property taxes

• Cost of general advertising

• Cost of general administration such as the plant

manager’s salary

COST BEHAVIOUR

COST - CLASSIFICATION

Costs can be classified into fixed, variable and

Semi-variable costs on the basis of:

Variability

Changes in cost behaviour in relation to change

in output, activity or volume where activity may

be indicated in any form such as units of output,

hours worked, sales etc.

FIXED COST

Cost which does not change for a given period

of time despite wide fluctuations in output or

volume of activity

Also known as standby costs, Capacity costs or

Period Costs.

Accrues with the passage of time and not with

the production of the product or the job, which

is why they are expressed in time such as per day

per month and not in terms of unit

Examples: Rent, Property Taxes, advertising etc.

CHANGES IN FIXED COSTS

Fixed costs remain fixed only in the short run

and so it is improper to say Fixed Costs do not

change.

0

20,000

40,000

60,000

80,000

100,000

120,000

0 20 40 60

To

tal

Co

stR

s. 1

,00,0

00

Volume (In Thousands)

FIXED COST

CHANGES IN FIXED COST

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 20 40 60 80 100

Fix

ed

Co

st (

Rs.

)

Relevant Range or volumeProduction Units (In Thousands)

Between 20,000 & 80,000 units of production, fixed cost is Rs.

50,000

In excess of 80,000 units, fixed cost becomes Rs. 60,000. This

assumes that increase in production after a certain level requires

increase in fixed expenses such as additional supervision,

increase in quality control costs.

CHANGES IN FIXED COST

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 20 40 60 80 100

Fix

ed

Co

st (

Rs.

)

Relevant Range or volumeProduction Units (In Thousands)

Between 20,000 & 80,000 units of production, fixed cost is Rs.

50,000

From 0 units (shut down) to 20,000 units, fixed cost is Rs.

25,000. If the level of activity comes to less than 20,000 units

some fixed costs may not be incurred such as costs on

accounting functions, supplies, staff and so on.

EXAMPLE

Costs of testing personal computers may not

change with a change in the volume of

production and would be fixed in the short run.

In the long run organization may need to

increase/ decrease testing department’s

equipment & staff to the levels needed to

support future production volumes .

So in the long run, volume of production or

activity becomes cost drivers of these testing &

staff costs.

FIXED COST-CLASSIFICATION

1. Committed costs: Incurred to maintain

Company’s facilities & physical existence.

Management has little or no discretion.

Examples: Plant & equipment depreciation,

taxes, insurance premium rate, rent charges etc.

2. Managed Costs: Related to current operations.

Paid to ensure the continued operating existence

of the company. Example: Management & Staff

salaries

FIXED COST-CLASSIFICATION

3. Discretionary costs: Result from special policy

decisions, management programmes, new

researches etc. Example: R&D Costs, Marketing

Programmes, new system development costs.

4. Step Costs: Constant for a given amount of

output and then increases in a fixed amount

after a higher output level.

STEP COSTS - EXAMPLE

In a manufacturing Company:

One supervisor required at a salary of Rs. 10,000 p.m. for every 50

workers.

As soon as 51st worker is employed, cost of supervision increases to

Rs. 20,000

Cost of supervision will go up if more than 100 workers are working.

VARIABLE COST

Costs which vary directly or proportionately

with the output.

Direct materials cost & direct labour cost are the

costs which are generally variable

Total variable costs change as more units are

produced, per unit variable cost remains

constant

Example: factory supplies, indirect materials,

sales commission, office supplies

VARIABLE COST

If a factory is shut down, variable costs are

eliminated

Expressed in terms of units or percentage of

volume

Cannot be stated in terms of time

VARIABLE COST-BEHAVIOUR

Behaviour pattern of direct material cost

For every increase in units produced, there is a proportionate

increase in costs

Cost of direct materials increases at a constant rate of Rs. 50 per

unit.

0

50,000

100,000

150,000

200,000

250,000

300,000

0 1000 2000 3000 4000 5000 6000To

tal

Dir

ect

Mate

rial

Co

st (

Rs.

)

Production Units

VARIABLE COST – LINEAR?

Variable cost may be linear only over the normal

range of activity levels

Beyond the normal range of activity, variable

cost per unit may show non-linear or curvi-

linear line implying variable costs are not varying

in direct proportion to output or activity

changes

VARIABLE COST - CONVEX

Where each extra unit of output causes a less

than proportionate increase in cost i.e.,

economies of scale operate

0

50,000

100,000

150,000

200,000

0 1000 2000 3000 4000 5000 6000

→C

ost

→ Level of Activity

Convex

VARIABLE COST - CONCAVE

Where each extra unit of output causes a more

than proportionate increase in cost i.e.,

diminishing returns operate

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

0 1000 2000 3000 4000

→C

ost

→ Level of Activity

Concave

VARIABLE COST–CURVI

LINEAR ?

In some production process, the amount of

waste materials remain more & more constant

So when production increases, unit variable cost

for material decreases due to economies of scale

On the other hand:

Diminishing returns will operate when it

becomes necessary to pay increasing differential

piece rates to increase production

A form of concave curvi–linear relationship will

emerge.

MIXED COST

Combination of semi-variable and semi fixed

costs.

Because of variable component – fluctuate with

volume

Because of fixed component – do not change in

direct proportion to output.

SEMI-FIXED COSTS

Costs which remain constant upto a certain level

of output after which they become variable.

0

10,000

20,000

30,000

40,000

50,000

60,000

0 1000 2000 3000 4000 5000 6000

To

tal

Co

sts

(Rs.

)

Units produced

SEMI-VARIABLE COSTS

Cost is basically variable but whose slope may

change abruptly when a certain output level is

reached.

0

5,000

10,000

15,000

20,000

25,000

30,000

0 1000 2000 3000 4000 5000

To

tal

Co

sts

(Rs.

)

Units Produced

MIXED COSTS

Mathematically mixed costs can be expressed as

follows:

Total Fixed Cost

Units x variable cost per

unit

Total Mixed Cost

EXAMPLE

Worker is paid a salary of Rs. 1500 per week

(fixed) plus a bonus of Re 1 for each unit

completed (variable). If he increases his weekly

output from 1000 units to 1500 units what is the

effect on his earnings?

Units produced 1,000 1,500

Fixed Component Rs. 1,500 Rs. 1,500

Variable Component Rs. 1,000 Rs 1,500

Total Rs. 2,500 Rs. 3,000

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