COST DRIVERS

• A critical first step for achieving a competitive advantage is to identify the key cost drivers in a
firm or organization.

• A cost driver is any factor that has the effect of changing the level of total cost.

• The management of the cost drivers is essential for a firm that competes on the basis of cost
leadership.

• For example, to achieve its low-cost leadership in manufacturing electronic products, Sony
Manufacturing watches carefully the design and manufacturing factors that drive the costs in its
products.

• For firms that are not cost leaders, the management cost drivers may not be as critical but
focusing attention to the key cost drivers contributes directly to the success of the firm.

• For example, an important cost drivers for retailers is loss and damage to merchandise so most
retailers have careful procedures for handling, displaying and storing merchandise.

EXAMPLES OF COST DRIVERS OF BUSINESS FUNCTIONS IN A VALUE CHAIN

BUSINESS FUNCTION COST DRIVER

Research and Development • Number of research projects

• Manpower hours on a project

• Technical difficulties of projects

Design of products, services and processes • Number of products in design

• Number of parts per product

• Number of engineering hours

Production • Number of units produced

• Direct manufacturing labor costs

• Number of set-ups

• Number of engineering change orders

BUSINESS FUNCTION COST DRIVER

Marketing • Number of advertisements run

• Number of sales personnel

 • Peso sales

Distribution • Number of items distributed

• Number of customers

• Weight of items distributed

Customer Service • Number of service calls

• Number of products serviced

• Hours spent servicing products

COST MANAGEMENT SYSTEM

Stage 1 – Cost Accumulation

• Cost Accumulation is the first stage in a manufacturing process of a product as cost object in a
manufacturing operation.

• It is the process of collecting or gathering cost data in an organized cost management system.

• The different cost elements in the manufacturing process are classified as: (a) direct material
cost, (b) direct labor cost, and (c) manufacturing overhead cost.

Stage 2 – Cost Assignment

• Cost assignment is the process of assigning costs to cost pools or from cost pools to cost objects.

• Cost allocation is the assignment of indirect costs to cost pools. Allocation bases are cost drivers
used to allocate costs.

• The second and final stage in the production process that encompasses both the tracing of
accumulated cost that have direct relationship to a product and the allocation of accumulated
cost that have an indirect relationship to a cost object or product.

• For managers to decide their planning stage, they need to identify the relationship of the
different cost elements in the product itself.

RELATIONSHIP OF DIFFERENT COST ELEMENTS

• Direct Cost – cost that is directly related to a particular cost object or product in the production
process, hence the direct materials and direct labor.

• Direct costs are conveniently and economically traceable to the cost object.

• Indirect costs cannot be economically traced to the cost object but instead are allocated to the
cost object.
 • Indirect Cost – cost that can be related to a cost object or product, but are not traceable in an
economically feasible way.

For example, the length of thread used in garments, bags and shoes.

For example, Toyota uses glue in manufacturing Tundra trucks but tracing that material would not be cost effective because the
cost amount is insignificant. The clerical and information-processing costs of tracing the glue cost to products would exceed any
informational benefits that management might obtain from the information. Thus, glue cost for each truck would be classified as
an indirect cost.

REACTION TO CHANGES IN ACTIVITY

• To manage cost effectively, one must understand how the different cost elements behave
relative to the changes in the level of production activity.

• To manage costs, accountants must understand how total (rather than unit) cost behaves relative
to a change in a related activity measure.

• Common activity measures include production volume, service and sales volumes, hours of
machine time used, pounds of material moved, and number of purchase orders processed.

• Every organizational cost will change if sufficient time passes or if an extreme shift in activity
level occurs. Thus, to properly identify, analyze, and use cost behavior information, a time frame
must be specified to indicate how far into the future a cost should be examined and a particular
range of activity must be assumed.

• The assumed range of activity that reflects the company’s normal operating range is referred to
as the relevant range.

• Within the relevant range, the two extreme cost behaviors are variable and fixed.