A Factor That Causes Overhead Costs Is Called A

One of the key elements in understanding business finances lies in grasping the concept of overhead costs and the underlying factors that contribute to their fluctuations. A primary driver of these costs is often referred to as a cost driver. This article explores the intricacies of cost drivers, shedding light on their significance in cost accounting and management decision-making.

Understanding Overhead Costs

Overhead costs encompass all indirect expenses incurred while running a business. These costs are not directly tied to the production of goods or services but are necessary to support the overall operations. Examples of overhead costs include rent, utilities, administrative salaries, insurance, and depreciation of equipment.

These costs are essential for maintaining the infrastructure and support systems that enable a company to function effectively. Managing overhead costs is crucial for profitability, as they can significantly impact the bottom line. Effective cost control strategies are vital for businesses seeking to optimize their financial performance.

What is a Cost Driver?

A cost driver is a factor that directly influences the amount of overhead costs incurred. It is an activity or variable that causes a change in the total cost of a particular activity. By identifying and understanding cost drivers, businesses can better allocate overhead costs, improve budgeting accuracy, and make informed decisions about resource allocation.

Types of Cost Drivers

Cost drivers can be broadly classified into two main categories: volume-related and activity-related.

1. Volume-Related Cost Drivers: These drivers are directly related to the volume of production or sales. As the volume increases, so do the overhead costs associated with it. Examples include:

   • Direct Labor Hours: The number of hours employees spend directly working on a product or service.
   • Machine Hours: The amount of time machines are used in the production process.
   • Units Produced: The total number of products manufactured.
   • Sales Revenue: The total income generated from sales.

2. Activity-Related Cost Drivers: These drivers are linked to specific activities within the organization. They are not directly tied to production volume but are essential for supporting the business operations. Examples include:

   • Number of Purchase Orders: The quantity of orders placed to procure raw materials or supplies.
   • Number of Setups: The frequency with which machines or equipment need to be set up for different production runs.
   • Number of Inspections: The amount of times products or processes are inspected for quality control.
   • Number of Customers: The size of the customer base that needs to be supported through marketing, sales, and customer service activities.
   • Number of Engineering Hours: The hours spent on product design, development, and engineering changes.

The Role of Cost Drivers in Cost Accounting

Cost drivers play a fundamental role in cost accounting by providing a basis for allocating overhead costs to specific products, services, or departments. Traditional cost accounting methods often use volume-related cost drivers, such as direct labor hours or machine hours, to allocate overhead costs. However, these methods may not accurately reflect the actual consumption of resources by different products or activities.

Activity-Based Costing (ABC) is a more refined approach that identifies and assigns costs to activities and then allocates these costs to products or services based on their consumption of activities. In ABC, activity-related cost drivers are used to allocate overhead costs more accurately.

How to Identify Cost Drivers

Identifying cost drivers requires a thorough understanding of the business processes and activities. Here are steps to help in the identification process:

1. Analyze Overhead Costs: Start by analyzing the various overhead costs incurred by the organization. Categorize these costs into different cost pools, such as rent, utilities, maintenance, and administration.
2. Identify Activities: Identify the key activities that drive these overhead costs. Activities can be classified into different levels, such as unit-level, batch-level, product-level, and facility-level activities.
3. Determine Cost Drivers: For each activity, determine the factors that cause it to occur. These factors are the cost drivers. For example, the number of purchase orders may be a cost driver for procurement activities, while the number of inspections may be a cost driver for quality control activities.
4. Collect Data: Gather data on the cost drivers and the related overhead costs. This data will be used to calculate the cost driver rate, which is the cost per unit of the cost driver.
5. Validate Cost Drivers: Validate the identified cost drivers by analyzing the relationship between the cost drivers and the overhead costs. Ensure that there is a strong correlation between the cost drivers and the costs they are supposed to drive.

Examples of Cost Drivers

To illustrate the concept of cost drivers, let’s consider some examples across different industries:

Manufacturing Industry

• Activity: Machine Maintenance
• Cost Driver: Machine Hours. The more hours the machines operate, the more maintenance is required.
• Activity: Quality Control Inspections
• Cost Driver: Number of Units Produced. The more units produced, the more inspections are needed to ensure quality.
• Activity: Production Setup
• Cost Driver: Number of Production Runs. Each time a new batch of products is produced, machines need to be set up, which incurs costs.

Service Industry

• Activity: Customer Support
• Cost Driver: Number of Customer Calls. The more customer calls, the higher the costs associated with customer support staff, phone systems, and related resources.
• Activity: Software Development
• Cost Driver: Number of Software Changes. The more changes required to the software, the more development and testing efforts are needed.
• Activity: Consulting Services
• Cost Driver: Number of Consulting Hours. The number of hours consultants spend on a project directly impacts the costs of providing consulting services.

Healthcare Industry

• Activity: Patient Care
• Cost Driver: Number of Patient Visits. The more patient visits, the more resources are required for patient care, including medical staff, supplies, and equipment.
• Activity: Laboratory Testing
• Cost Driver: Number of Tests Performed. The number of tests performed directly affects the costs of laboratory supplies, equipment maintenance, and technician time.
• Activity: Hospital Administration
• Cost Driver: Number of Admissions. The more patients admitted, the more administrative work is required for processing paperwork, insurance claims, and other related tasks.

Using Cost Drivers for Overhead Allocation

Once cost drivers have been identified, they can be used to allocate overhead costs to products, services, or departments. The allocation process typically involves the following steps:

1. Calculate the Cost Driver Rate: Divide the total overhead cost by the total amount of the cost driver. This gives you the cost per unit of the cost driver.

   Cost Driver Rate = Total Overhead Cost / Total Amount of Cost Driver

2. Allocate Overhead Costs: Multiply the cost driver rate by the amount of the cost driver consumed by each product, service, or department. This gives you the amount of overhead costs to allocate to each.

   Allocated Overhead Cost = Cost Driver Rate x Amount of Cost Driver Consumed

Example of Overhead Allocation Using Cost Drivers

Consider a manufacturing company that produces two products: Product A and Product B. The company has total overhead costs of $500,000 and uses machine hours as the cost driver. The total machine hours for the company are 10,000 hours. Product A uses 6,000 machine hours, while Product B uses 4,000 machine hours.

1. Calculate the Cost Driver Rate:

   Cost Driver Rate = $500,000 / 10,000 hours = $50 per machine hour

2. Allocate Overhead Costs:

   Product A: Allocated Overhead Cost = $50 x 6,000 hours = $300,000

   Product B: Allocated Overhead Cost = $50 x 4,000 hours = $200,000

In this example, $300,000 of overhead costs is allocated to Product A, and $200,000 is allocated to Product B, based on their consumption of machine hours.

Benefits of Using Cost Drivers

Using cost drivers to allocate overhead costs provides several benefits:

1. Improved Cost Accuracy: Cost drivers provide a more accurate way to allocate overhead costs compared to traditional methods. By using activity-related cost drivers, businesses can better reflect the actual consumption of resources by different products or services.
2. Enhanced Decision-Making: Accurate cost information is essential for making informed decisions. By understanding the cost drivers, businesses can better assess the profitability of different products, services, or departments and make decisions about pricing, product mix, and resource allocation.
3. Better Cost Control: By identifying the factors that drive overhead costs, businesses can focus on managing those factors to control costs. This can lead to more efficient operations and improved profitability.
4. Improved Budgeting: Cost drivers can be used to develop more accurate budgets. By understanding the relationship between cost drivers and overhead costs, businesses can better predict future costs and plan accordingly.
5. Performance Measurement: Cost drivers can be used to measure the performance of different departments or activities. By tracking the amount of the cost driver consumed by each department, businesses can assess their efficiency and identify areas for improvement.

Challenges of Implementing Cost Drivers

While using cost drivers offers numerous benefits, there are also challenges associated with their implementation:

1. Complexity: Identifying and tracking cost drivers can be complex, especially in organizations with diverse activities and processes. It requires a thorough understanding of the business operations and the ability to collect and analyze data.
2. Data Availability: Accurate data on cost drivers may not always be readily available. Businesses may need to invest in systems and processes to collect and track the necessary data.
3. Cost of Implementation: Implementing cost drivers can be costly, especially if it requires changes to existing systems and processes. Businesses need to weigh the costs and benefits of implementation to determine if it is worthwhile.
4. Resistance to Change: Implementing cost drivers may require changes to existing roles and responsibilities, which can lead to resistance from employees. It is important to communicate the benefits of using cost drivers and involve employees in the implementation process to minimize resistance.
5. Maintaining Accuracy: Cost drivers need to be regularly reviewed and updated to ensure that they remain accurate and relevant. Changes in business operations, technology, or market conditions may require adjustments to the cost drivers.

Cost Driver vs. Activity Driver

It’s easy to confuse cost drivers with activity drivers, as they’re closely related. An activity driver measures the frequency and intensity of demands on activities by cost objects. It's used to assign activity costs to cost objects. A cost driver, on the other hand, is the root cause of why an activity is performed. It directly influences the total cost of an activity.

Conclusion

Cost drivers are essential factors that influence overhead costs in a business. By identifying and understanding cost drivers, businesses can more accurately allocate overhead costs, improve decision-making, and enhance cost control. While implementing cost drivers can be challenging, the benefits they provide make them a valuable tool for cost accounting and management. Embracing cost drivers allows businesses to achieve better financial performance and maintain a competitive edge in today's dynamic business environment.