As you’ve learned, the most common bases for predetermined overhead are direct labor hours, direct labor dollars, or machine hours. Each of these costs is considered a cost driver because of the causal relationship between the base and the related costs: As the cost driver’s usage increases, the cost of overhead increases as well. Table 9.1 shows various costs and potential cost drivers.
|Common Expenses||Potential Cost Drivers|
The more accurately a company can determine the cost drivers for its products, the more accurate the costing information will be, which in turn allows management to make better use of the cost data in making decisions. As technology changes, however, the mix between materials, labor, and overhead changes. Often, improved technology means less waste of material and fewer direct labor hours, but possibly more overhead. For example, technology has changed the way pharmaceuticals are manufactured. Advancing technology allows for the now smaller labor force to be more productive than a larger labor force from earlier years. While the labor cost has changed, this decrease may only be temporary as a labor force with higher costs and different skills is often needed. Additionally, an increase in technology often raises overhead costs. How accurate, then, is the company’s product cost information if it has become more efficient in its production process? Should the company still be using a predetermined overhead application rate based on direct labor hours or machine hours? A detailed analysis of the cost drivers will answer these questions.
Another benefit of looking at cost drivers is that doing so allows a company to analyze all costs. A company can differentiate among costs that drive overhead and have value, those that do not drive overhead but still add value, and those that may or may not drive the overhead but do not add any value. For example, a furniture manufacturer produces and sells wooden tables in various colors. The painting process involves a white base coat, a color coat, and a clear protective top coat. The three coats are applied in a sealed room using a spraying process followed by an ultraviolet drying process. The depreciation on the spraying machines and the ultraviolet bulbs used in the painting process are overhead costs. These costs drive or increase overhead, and they add value to the product by increasing the quality. Costs associated with repainting or fixing any blemishes are overhead costs that are necessary to sell the product but would not be considered value-added costs. The goal is to eliminate as many of the non-value-added costs as possible and subsequently reduce overhead costs.
Cost Drivers and Overhead
In today’s production environment, there are many activities within the production process that can contribute to the cost of the product, but determining the cost drivers may be complicated because some of those activities may change over time. Additionally, the appropriate level of assigning cost drivers needs to be determined. In some cases, overhead costs such as inspection increase with each unit inspected, and the costs need to be allocated on a per-unit level. In other cases, the overhead costs, such as machine setup costs, are incurred each time a batch of products is manufactured and need to be allocated at the batch level.
For example, the labor hours for the staff taking, fulfilling, and inspecting orders may increase as the number of orders increases, driving up the overhead. Furthermore, the costs of taking orders or of quality inspections can vary per product and may not be captured properly. Technology improvements, including switching to automated processes for production, may decrease the labor hours of the production staff, driving the labor-related overhead downward but potentially increasing other overhead expenses. These activities—order taking, fulfillment, and quality inspections—are potential cost drivers associated with production, and they each drive the overhead at varying rates.
Identify Cost Drivers
How does a company determine its cost drivers for indirect materials, indirect labor, and other overhead costs? To begin the determination of appropriate cost drivers, an accountant analyzes the activities in the product production process that contribute to the cost of that product. An activity is any action that consumes company resources, such as taking orders for a product, setting up machines to produce the product, inspecting the product, and providing customer support before and through the order process. For example, Musicality’s direct costs can be traced to the products, but there are indirect costs associated with using various types of material for each product. While the Orchestra product has more intricate materials and labor, it has fewer costs associated with requisitioning and conveying materials to the production line than the other products have. Additionally, examining the inspection costs indicates the Orchestra product is a simple product to inspect, so random quality inspections are sufficient. But individual inspections for both the Solo and Band products are critical, and the overhead related to inspection costs should be based on the number of inspections.
As you can imagine, the unique aspects of the production process for each product affect the overhead cost of each product. However, these costs may not be allocated to the products appropriately when overhead is applied using a predetermined rate based on one activity. While Solo, Band, and Orchestra might appear to be different only in quality, they are actually very different from each other when it comes to manufacturing overhead costs.
Whether the products produced require significantly different overhead resources or not, the company benefits from understanding what its cost drivers are. The more efficiently each product’s activities are tracked, the more actual cost drivers are discovered, and the more accurately overhead can be assigned to each product.
CONCEPTS IN PRACTICE
Cost Drivers for Small Businesses
The value of analyzing cost drivers can be used in budgeting beyond allocating overhead to products. American Express has forums designed to help small businesses be successful. Knowing the cost drivers for your business can help with budgeting. American Express states that all business activities are related to five main cost drivers:3
- Employee head count is often the driver for office supply expense.
- Salesperson head count is often the driver for auto and other employee travel expense.
- The number of leads required to reach the target sales goal is often the driver for advertising, public relations, social media, search engine optimization expense, and other expenses associated with generating leads.
- Sales and all related variable expenses are often the driver for commissions, bad debt, insurance expense, and so on.
- Fixed costs, such as postage, web hosting fees, business licenses, and banking fees, are often overlooked as cost drivers.
- 3 American Express. “5 Cost Drivers to Help You Make Accurate Expense Projections.” June 23, 2011. https://www.americanexpress.com/us/small-business/openforum/articles/5-cost-drivers-to-help-you-make-accurate-expense-projections/