Improving Performance with Cost Drivers

IMPROVING PERFORMANCE WITH COST DRIVERS Due to changes in manufacturing, the traditional overhead allocation method can lead to inaccurate products costs. Frank Collins, CPA, professor of accounting, and Michael L. Werner, CPA, lecturer in accounting at the University of Miami, Coral Gables, Florida, illustrate how the new cost-driver approach can improve cost management. Traditionally, most companies allocated costs to production using application bases such as direct labor. However, as businesses become more capital intensive and production methods change, this procedure can lead to inaccurate determinations of product costs. The new cost-driver approach can remedy this situation. USING COST DRIVERS The cost-driver approach allocates a cost to production, based on the actions or factors that cause it. For example, the cleanup costs of a printing press might be allocated based on the number of colors used. As illustrated in the sidebar on TRADITIONAL vs. COST-DRIVER APPROACHES this results in more accurate costing. The exhibit on Basic work phases and cost drivers shows typical cost drivers for the various stages of work (planning, getting ready to work, working, finishing and inspecting work). Examining the second stage--getting ready to work--we find activities that contribute costs to this stage include ordering raw materials and setting up machines. After accumulating applicable costs in pools, cost drivers are used to allocate these cost pools to production. Potential cost drivers for this second stage include the number of production runs or machine set-ups. If it is determined the number of production runs is the most appropriate cost driver, this pool is allocated to production in proportion to the number of production runs necessary to make the product. TRADITIONAL APPROACH How does this approach differ from the traditional one? Traditionally, costs are pooled and allocated to production as a function of direct labor hours or machine hours. These bases are used because it is assumed that, over the long run, factory costs are likely to be highly correlated with one of these measures. But because of changes in manufacturing this is often no longer true. A rate per hour is determined and used to allocate each cost pool to the product. See the sidebar below for a comparison of the traditional and cost-driver approaches to allocating cleanup costs in a printing company. BETTER COSTING AND CONTROL The chief benefit of the cost-driver approach is that it provides better product costing for individual products. Accurate product costs are invaluable when setting sales prices, evaluating product lines for discontinuance or developing marketing and production strategies. The manager who wants to control costs now looks to controlling their causes--the cost drivers. Using the traditional method, a manager wishing to reduce overhead cost allocations to his or her department seeks to reduce direct labor hours (or whatever the allocation basis happens to be), a practice not likely to get at the root causes of the costs. Using the cost-driver approach, accountants and managers look for the events and activities that cause costs. OTHER BENEFITS Beyond better product costing and control, the tangible benefits of identifying cost drivers include: Eliminating and reducing cost. After identifying cost drivers, the natural next step--to see if some of these costs can be eliminated or reduced--is greatly facilitated. Highlighting cost of complexity. Maintaining an elaborate product line is costly, particularly when it results in short and numerous production runs. Usually these costs are not separated and thus are hidden. In the search for cost drivers, they will be disclosed and associated with individual products. Though marketing strategy may continue to call for having an elaborate product line, the costs will be more apparent. …