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Chapter 2: Problem 6

What is a cost driver? Give one example.

Short Answer

Expert verified
A cost driver is an activity or factor that influences the level of cost incurred within an organization, serving as a basis for assigning indirect costs to products, services, or other cost objects. One example of a cost driver is the number of machine hours used in a manufacturing facility, which indirectly influences the total cost of production as more machine hours result in higher costs associated with operating, maintaining, and servicing the machinery.

Step by step solution

01

Define a Cost Driver

A cost driver is an activity or factor that influences the level of cost incurred within an organization. It is a specific measure or event that can be used as a basis for assigning indirect costs to products, services, or other cost objects.
02

Give an Example of a Cost Driver

One example of a cost driver is the number of machine hours used in a manufacturing facility. The more machine hours used, the higher the total cost of production, as it depends on the costs associated with operating, maintaining, and servicing the machinery. In this case, machine hours drive the cost of production indirectly, as more machine hours result in higher costs to the organization.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Indirect Costs
Indirect costs are the expenses that are not directly linked to the production of goods or services. These are costs that cannot be traced back to a single cost object easily.
They include expenses like utilities, rent, and administrative salaries that are necessary for overall operations but are challenging to assign directly to a specific product.
There are two main categories of indirect costs:
  • Fixed Indirect Costs: These remain constant regardless of the level of production or sales, such as rent or executive salaries.
  • Variable Indirect Costs: These fluctuate with changes in production volume, like factory supplies.
Understanding indirect costs is important because it helps in assessing the true cost and profitability of producing a product or service. These costs must be allocated to ensure accurate financial statements.
Cost Allocation
Cost allocation is the process of distributing indirect costs across different products, services, or departments. The purpose is to assign these costs in a manner that reflects the usage of resources.
This process involves selecting a suitable method to apportion costs, ensuring that each product or service is carrying its fair share of the indirect expenses. There are several methods of cost allocation:
  • Direct Allocation: Assigning costs directly to a cost object despite being indirect. This method is used when costs can be linked closely to the cost object.
  • Step-Down Method: Allocates costs in a sequential manner, where once a department's costs are allocated, that department is excluded from future allocations.
  • Activity-Based Costing (ABC): Allocates costs based on actual activities that drive costs, often using multiple cost drivers, like machine hours or labor hours.
Correct cost allocation leads to more precise pricing strategies and profitability analysis. It helps in making informed managerial decisions by depicting an accurate cost structure of the enterprise.
Manufacturing Costs
Manufacturing costs are the expenses incurred in the production of goods. These costs include all the necessary expenditures for creating a product, covering materials, labor, and overheads.
They are generally divided into three categories:
  • Direct Materials: Raw materials that are directly traceable to the finished product.
  • Direct Labor: The cost of employees directly involved in the manufacturing process. Think of wages for workers on an assembly line.
  • Manufacturing Overhead: All the other costs that are not directly traceable to the product. This includes indirect costs like utilities for the production area, equipment depreciation, and a portion of supervisory wages.
For effective management of these costs, it is crucial to understand the breakdown and contribution of each category.
By doing so, businesses can analyze their efficiency, calculate unit costs, and set competitive pricing.
This understanding also ties into cost drivers, as certain activities will influence the level of manufacturing costs incurred, helping refine control and optimization strategies.

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Most popular questions from this chapter

Define product cost. Describe three different purposes for computing product costs.

What is the relevant range? What role does the relevant-range concept play in explaining how costs behave?

Computing and interpreting manufacturing unit costs. Minnesota Office Products (MOP) produces three different paper products at its Vaasa lumber plant: Supreme, Deluxe, and Regular. Each product has its own dedicated production line at the plant. It currently uses the following three-part classification for its manufacturing costs: direct materials, direct manufacturing labor, and manufacturing overhead costs. Total manufacturing overhead costs of the plant in July 2017 are \(\$ 150\) million (\$15 million of which are fixed). This total amount is allocated to each product line on the basis of the direct manufacturing labor costs of each line. Summary data (in millions) for July 2017 are as follows: $$\begin{array}{lccc} & \text { Supreme } & \text { Deluxe } & \text { Regular } \\ \hline \text { Direct material costs } & \$ 89 & \$ 57 & \$ 60 \\ \text { Direct manufacturing labor costs } & \$ 16 & \$ 26 & \$ 8 \\ \text { Manufacturing overhead costs } & \$ 48 & \$ 78 & \$ 24 \\ \text { Units produced } & 125 & 150 & 140 \end{array}$$ 1\. Compute the manufacturing cost per unit for each product produced in July 2017 . 2\. Suppose that, in August 2017 , production was 150 million units of Supreme, 190 million units of Deluxe, and 220 million units of Regular. Why might the July 2017 information on manufacturing cost per unit be misleading when predicting total manufacturing costs in August \(2017 ?\)

Total and unit cost, decision making. Gayle's Glassworks makes glass flanges for scientific use. Materials cost \(\$ 1\) per flange, and the glass blowers are paid a wage rate of \(\$ 28\) per hour. A glass blower blows 10 flanges per hour. Fixed manufacturing costs for flanges are \(\$ 28,000\) per period. Period (nonmanufacturing) costs associated with flanges are \(\$ 10,000\) per period and are fixed. 1\. Graph the fixed, variable, and total manufacturing cost for flanges, using units (number of flanges) on the \(x\) -axis. 2\. Assume Gayle's Glassworks manufactures and sells 5,000 flanges this period. Its competitor, Flora's Flasks, sells flanges for \(\$ 10\) each. Can Gayle sell below Flora's price and still make a profit on the flanges? 3\. How would your answer to requirement 2 differ if Gayle's Glassworks made and sold 10,000 flanges this period? Why? What does this indicate about the use of unit cost in decision making?

Labor cost, overtime, and idle time. David Letterman works in the production department of Northeast Plastics (NEP) as a machine operator. David, a long- time employee of NEP, is paid on an hourly basis at a rate of \(\$ 24\) per hour. David works five 8 -hour shifts per week Monday-Friday (40 hours). Any time David works over and above these 40 hours is considered overtime for which he is paid at a rate of time and a half \((\$ 36\) per hour). If the overtime falls on weekends, David is paid at a rate of double time (\$48 per hour). David is also paid an additional \(\$ 24\) per hour for any holidays worked, even if it is part of his regular 40 hours. David is paid his regular wages even if the machines are down (not operating) due to regular machine maintenance, slow order periods, or unexpected mechanical problems. These hours are considered "idle time." During December David worked the following hours: Included in the total hours worked are two company holidays (Christmas Eve and Christmas Day) during Week \(4 .\) All overtime worked by David was Monday- Friday, except for the hours worked in Week 3 ; all of the Week 3 overtime hours were worked on a Saturday. 1\. Calculate (a) direct manufacturing labor, (b) idle time, (c) overtime and holiday premium, and (d) total earnings for David in December. 2\. Is idle time and overtime premium a direct or indirect cost of the products that David worked on in December? Explain.
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