In this lesson, we will learn about cost drivers. We will define the term, look at examples, and learn the steps a company might take when analyzing a cost driver. The lesson will conclude with a summary and a quiz.
What Is a Cost Driver?
Let’s imagine that you have just opened a new business. At your place of business, you sell various electronics ranging from computers to televisions to car stereos. Since electronics always seem to be in demand, you hope to have had great success with your new business.
However, after about three months in business, you realize that the costs that you incurred are significantly higher than anticipated. These costs have begun to cut into your profits, and it’s time to figure out what’s happening.You soon realize that a particular brand of car stereos have had an abundance of returns, because the volume button does not work well.
It was at that time that you also realized that those returns have become a cost driver.
Definition of Cost Driver
So you may be wondering, what is meant by the term cost driver? Well, a cost driver is a unit of activity that causes a business to endure costs. So, your business was incurring costs via returns by customers. Therefore, the cost driver for your business was products returned by customers.
Examples of Cost Drivers
Let’s take a minute to look at some common costs drivers that affect businesses:
- Direct labor: this is exactly what the name indicates – the employees needed to work for a business
- Setting up equipment: Many businesses need machines in order to conduct business, often required to manufacture a product
- Special instructions: Sometimes customers have specific demands about products.
When this happens, a company incurs costs.
- Handling and storage: if a company needs to store its products, it may have to pay for that storage. If a company has to pay employees or companies to handle products, like getting them ready to ship, there are also costs.
- Components: A company may be incurring costs based on the components in the products it produces. Obviously, the more components in a product, the higher the costs.
From our example earlier, stereos have a lot of components, which means they cost more money to produce than, say, a rubber ball.
- Machine hours: Like mentioned earlier, machines are often used to produce goods. The amount of hours that a machine runs to make those products is often a cost driver for companies.
- Returns: When customers return products, businesses have to endure costs, such as restocking the item.
Analyzing Cost Drivers
In order for a company to be successful, it is important for a company to identify costs incurred and what activity caused them.
So how does a business do this? The following steps show the process a business might take in order to analyze cost drivers:
- Identify the cost: A business needs to first find its costs. What is causing a business to incur costs?
- Investigate: The next step is finding out if there is any relationship between a cost and an activity. For example, does a company incur higher costs when using packing peanuts versus bubble wrap? Is there a cheaper alternative to packing items?
- Identify correlation: After a plausible relationship has been identified, a company can better understand the correlation. If, for instance, a company finds out that packing items creates a higher cost than expected, it then needs to determine what is causing that high packing cost. Maybe packing peanuts costs double the price of bubble wrap and is, therefore, the cost driver.
- Analyze: This basically answers the question, How will a company manage the cost driver?
- Wrap up: Once a measure is chosen to manage the cost driver, a company needs to determine if the measure is working.
A cost driver is a unit of activity that causes a company to incur costs. Some examples are:
- Direct labor
- Machine use
- Handling and storage
In order to analyze cost drivers, a company can follow five steps starting from identification and ending with determining if the measure enacted is working to control or minimize costs. These steps are:
- Identify the cost
- Identify correlation
- Wrap up