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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

Explain why unit costs must often be interpreted with caution.

Classification of costs, manufacturing sector. The Cooper Furniture Company of Potomac, Maryland, assembles two types of chairs (Recliners and Rockers). Separate assembly lines are used for each type of chair Classify each cost item (A-I) as follows: a. Direct or indirect (D or I) cost for the total number of Recliners assembled. b. Variable or fixed (V or F) cost depending on how total costs change as the total number of Recliners assembled changes. (If in doubt, select on the basis of whether the total costs will change substantially if there is a large change in the total number of Recliners assembled. You will have two answers (D or I; V or F) for each of the following items: Cost Item A. cost of fabric used on Recliners B. Salary of public relations manager for Cooper Furniture C. Annual convention for furniture manufacturers; generally Cooper Furniture attends D. cost of lubricant used on the Recliner assembly line E. Freight costs of Recliner frames shipped from Durham to Potomac, MD F. Electricity costs for Recliner assembly line (single bill covers entire plant) G. Wages paid to temporary assembly-line workers hired in periods of high Recliner production (paid on hourly basis) H. Annual fire-insurance policy cost for Potomac, MD plant I. Wages paid to plant manager who oversees the assembly lines for both chair types

Year 1 financial data for the ABC Company is as follows: Sales\(\quad$$\$ 5,000,000\) Direct materials\(\quad\)850,000 Direct manufacturing labor\(\quad\)1,700,000 Variable manufacturing overhead\(\quad\)400,000 Fixed manufacturing overhead\(\quad\)750,000 Variable \(\mathrm{SG} \& \mathrm{A}$$\quad\)150,000 Fixed \(\mathrm{SG} \& \mathrm{A}$$\quad\)250,000 Under the absorption method, Year 1 cost of Goods sold will be: a. \(\$ 2,550,000\) b. \(\$ 2,950,000\) c. \(\$ 3,100,000\) d. \(\$ 3,700,000\)

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

Classification of costs, service sector. Market Focus is a marketing research firm that organizes fo cus groups for consumer-product companies. Each focus group has eight individuals who are paid \(\$ 60\) per session to provide comments on new products. These focus groups meet in hotels and are led by a trained independent marketing specialist hired by Market Focus. Each specialistis paid a fixed retainer to conductt a minimum number of sessions and a per session fee of \(\$ 2,200\). A Market Focus staff member attends each session to ensure that all the logistical aspects run smoothly. Classify each cost item (A-H) as follows: a. Direct or indirect (D o r I) costs of each individual focus group b. Variable or fixed (V or F) costs of how the total costs of Market Focus change as the number of focus groups conducted changes. (If in doubt, select on the basis of whether the total costs will change sub stantially if there is a large change in the number of groups conducted. You will have two answers (D or l; V or F) for each of the following items: Cost Item. A. Payment to individuals in each focus group to provide comments on new products. B. Annual subscription of Market Focus to Consumer Reports magazine. C. Phone calls made by Market Focus staff member to confirm individuals will attend a focus group session (Records of individual calls are not kept.) D. Retainer paid to focus group leader to conduct 18 focus groups per year on new medical products. E. Recruiting cost to hire marketing specialists. F. Lease payment by Market Focus for corporate office. G. cost of tapes used to record comments made by individuals in a focus group session (These tapes are sent to the company whose products are being tested.) H. Gasoline costs of Market Focus staff for company-owned vehicles (Staff members submit monthly bills with no mileage breakdowns.) I. costs incurred to improve the design of focus groups to make them more effective.
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