Identifying Cost Drivers

Learning Outcomes

  • Identify cost drivers and compute allocation rates

Exterior of a factory buildingUnder the ABC system, the terms “cost driver” and “activity driver” are used to refer to the allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders. Just like it sounds, the main activity that consumes resources is the cost driver. It is literally driving the costs in that part of the process.

There are two categories of cost drivers: transaction drivers, which involves counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Common ABC systems use broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity, unit-level activity, organization-level activity, and product-level activity. Also, these are not carved in stone. Different organizations use different categories and terminology, but the basic concepts are the same.

Here are some examples of each:

  • Batch-level activity: Setting up a run of a certain product
    • Transaction driver: # batches
  • Unit-level activity: Inspections (for quality control purposes)
    • Transaction driver: # of inspections performed
  • Organization-level activity: Equipment maintenance
    • Duration driver: number of machine hours
  • Product-level activity: Production Supervisors
    • Duration driver: number of direct labor hours

A factory overhead rate for each routinely-performed activity is calculated by dividing the total budgeted cost amount for the activity for a period by the total cost driver over the same time frame. The fraction for each activity is similar to the one used for the predetermined single factory rate, except at a more micro level.

There may still be some factory overhead costs that are not associated with any particular activity or cost driver, such as factory expenses like utilities, maintenance, insurance, and building depreciation. These general overhead costs will be applied to jobs, product lines, and individual products using the best cost driver available, which will probably be direct labor hours or direct labor dollars.

For instance, if Yore Company plans to produce 3,760 units during the month of October and has budgeted $28,200 for the setup function (cost pool) in the production department, and if each run of product is done in batches of 80 with a setup for each run, there would be 47 batches in total (3,760 / 80). Therefore, the cost of each setup would be $600 ($28,200 / 47).

The batch-level activity (cost pool) is setups. The cost driver is # of batches. The more batches we run, the more times we need to set up the production line. The rate is $600 per batch. Since these people are not making any particular product, their salaries and other expenses of that function are included in indirect factory overhead.

Let’s assume that Yore Company has budgeted $141,000 for production overhead (building maintenance, supervisor salaries, etc.) and has decided to allocate that cost pool using direct labor hours. Total budgeted direct labor hours are 18,800, so the predetermined allocation rate for that cost pool is $7.50 per direct labor hour ($141,000 / 18,800).

Finally, the company has budgeted $18,800 for quality assurance and plans to test 576 basic purses (about 18% of the total) and 364 deluxe purses (about 65% of the total). The allocation rate would be $20 per test ($18,800 / (576+364)).

Here is a quick review of the process of setting ABC rates:

You can view the transcript for “Activity Based Costing (Part 1) Cost Pools and 1st Stage Allocation” here (opens in new window).

Before we apply these allocation rates to the activity bases, check your understanding of the process of setting rates.

Practice Question