ACCTF 533, Section 1: Module 1: Costs and Cost Allocation: Lecture 2: Cost Drivers and
Cost Allocation
[Slide Content]:
Cost Drivers and Cost Allocation
[Jeanne H. Yamamura]:
Cost Drivers and Cost Allocation:
Now that we have a basic understanding of cost concepts and terminology, we can move to cost
management. Managing costs is typically done by focusing on management of the activities
being performed, rather than on the products or services directly.
[Slide Content]:
Cost Management
To forecast and manage costs
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Key business activities performed
Resources consumed in performing these activities
Costs of the resources used
Cost drivers
[Jeanne H. Yamamura]:
In order to forecast and manage costs, the following need to be identified: What key business
activities is the entity performing? What resources are consumed in performing these activities?
What are the costs of the resources used? And what are the cost drivers?
[Slide Content]:
Value Chain Analysis
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Michael Porter, 1985, “The Competitive Advantage”
To create product or provide service
o Set of activities (business functions)
o Value adding/non-value adding
Identify and focus on value-added activities
Competitive advantage
[Jeanne H. Yamamura]:
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To identify key business activities performed, the organization will ideally have conducted a
value chain analysis. The value chain concept was originated by Michael Porter in his book
“The Competitive Advantage” in 1985. The basic idea is that the organization conducts a series
of activities (or a set of business functions) in creating a product or providing a service. Not all
activities or functions, however, add value. The organization will perform best if it is able to
identify and focus on improving the value-added activities. This will enable the organization to
maintain a competitive advantage in the marketplace.
[Slide Content]:
Resource Costs and Cost Drivers – National Pizza Chain
Value Chain Function
Research & development
Design
Production
Marketing
Resource Cost
Salaries of food scientists
Ingredient costs
Wages for hourly employees
Advertising costs
Distribution
Customer service
Delivery costs, e.g. fuel
Salaries of customer service
personnel
Possible Cost Drivers
# of new product ideas
Complexity of new products
Labor hours
# of ads, size of ads (inches,
minutes)
# of deliveries, distance
# of requests, # of complaints
[Jeanne H. Yamamura]:
Once the key business activities are identified, then the resources consumed in performing each
activity can be identified. The next steps are to identify the costs of the resources and the cost
drivers for those costs.
Here are some examples of resource costs and possible cost drivers for common value chain
functions for a national pizza restaurant chain:
For the value chain function of research and development we have as a possible resource cost
salaries of food scientists. The cost driver: number of new product ideas.
For design, we have a resource cost of ingredients, and the possible cost driver: complexity of
new products.
For the value chain function of production, how about wages for hourly employees, and the cost
driver here would be labor hours.
In marketing, as a resource cost we have advertising, and possible cost drivers for advertising:
number of ads or size of ads in perhaps inches or minutes.
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For distribution, we have delivery costs, for example, fuel costs, and possible cost drivers are the
number of deliveries or the distance.
The final area, customer service, we have salaries of customer service personnel, and the cost
drivers: number of requests or number of complaints.
[Slide Content]:
The Problems with Cost Drivers
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More than one cost driver
Not always visible
Not always counted
[Pictures Shown]
[Jeanne H. Yamamura]:
Figuring out the resources consumed and the cost of those resources generally doesn’t cause a
problem. What does cause a problem is identifying the cost driver. Remember that a cost driver
is a factor that causes activity costs to change. An activity can have more than one cost driver.
For example, think about a dressmaking shop and the activity of making a dress and the resource
cost of the labor required. The labor costs are driven by: the type of fabric, how much of the
dress is machine sewn, the complexity of the design, and the amount of detail to be added, for
example, beading or embroidery.
You have to be able to determine what is driving the activity or process. It is often something
visible only when you review the process step by step, for example, by looking at a flowchart or
a process map. As another example think about the Purchasing function. If you looked only at
the general ledger summary of costs for the Purchasing division, you would see payroll, rent,
utilities, office supplies – all of the normal operating expenses for an administrative division.
What you won’t see is purchase orders. Yet purchase orders drive the Purchasing function.
[Slide Content]:
Cost Allocation
[Picture of a Printer]
Cost driver = Direct labor $
Overhead Costs
Indirect materials
Indirect labor
Manufacturing equipment – depreciation
Amount
$25,000
$10,000
$175,000
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Factor costs, e.g. rent, utilities
Total cost
Expected DL$
Total cost $305,000 / Expected DL$ 12,200
$95,000
$305,000
$12,200
$25 per DL$
[Jeanne H. Yamamura]:
Why do we care about cost drivers? Because they are used to allocate resource costs.
Let’s look at an example.
Suppose that Hewlett Packard has a factory in which it manufactures 10 different types of
printers. The cost of each printer consists of direct materials, direct labor, and manufacturing
overhead. HP has decided to lump all overhead costs together in a single pool and to allocate the
overhead costs to each product based on direct labor dollars.
First, let’s look at the cost allocation. All of the overhead costs are added up. We have $25,000
in indirect materials, $10,000 in indirect labor, $175,000 in depreciation on manufacturing
equipment, and factory costs like rent and utilities of $95,000. The grand total is $305,000. We
divide that by the expected Direct Labor Cost of $12,200 because we have decided to use Direct
Labor dollars as our cost driver. Our overhead rate is $25 per Direct Labor $.
[Slide Content]:
Cost Drivers Allocate Costs
Printer 101 Cost
Direct materials
Direct labor
Overhead ($35 per DL$)
Total cost
Amount
$13.90
1.10
27.50
$42.50
[Jeanne H. Yamamura]:
As a result, Printer 101 has the following costs: Direct materials $13.90, Direct labor $1.10,
Overhead (which, again, is being allocated based on Direct Labor dollars): the overhead cost is
$27.50. So the total cost of printer 101 is $42.50.
Based on these numbers, HP must price the printer above $42.50 if it wants to sell the printer at a
profit.
Notice, however, the very small amount of cost for direct labor. Because of heavy automation of
the manufacturing process, direct labor has become a smaller and smaller portion of product cost
for HP. In fact, HP reported that direct labor had dropped to only 3% of the total manufacturing
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costs. And the bulk of the cost was now appearing in overhead as that is where the cost of the
manufacturing equipment is included. Does it make sense to continue using direct labor dollars
as the cost driver?
[Slide Content]:
Implications of Cost Choices
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In past, common drivers – volume, time
Today, closer look at cost drivers and cost allocation methods
Each choice has different implications
Each choice will change behavior
[Jeanne H. Yamamura]:
In the past, the most common drivers were volume or time, for example, number of pieces
produced or labor hours worked. These were used because of ease of application and ready
availability of the information that was needed. Today, however, organizations actively working
to manage and control costs have found themselves taking a closer look at cost drivers and cost
allocation methods. There are many more choices for cost drivers AND each choice has
different implications – cost distribution is different, different measurement problems arise.
Even more critical, the choice of a cost allocation method and cost driver will change behavior
and the behavioral changes may not be exactly what were expected.
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