Cost Driver

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Cost Driver

  1. 1. COST DRIVERSCOST DRIVERS && COST BEHAVIOURCOST BEHAVIOUR Dr. Rana SinghDr. Rana Singh www.ranasingh.orgwww.ranasingh.org
  2. 2. COST DRIVER - DEFINITIONCOST DRIVER - DEFINITION  An activity which generates costAn activity which generates cost  A factor such as the level of activity or volumeA factor such as the level of activity or volume that causally affects cost.that causally affects cost.  Existence of a cause-and-effect relationshipExistence of a cause-and-effect relationship between a change in the level of activity orbetween a change in the level of activity or volume and change in the level of total costs ofvolume and change in the level of total costs of that cost object.that cost object.  Thus cost drivers signify factors, forces orThus cost drivers signify factors, forces or events that determine the costs of activitiesevents that determine the costs of activities
  3. 3. COST DRIVER - IDENTIFIEDCOST DRIVER - IDENTIFIED  Direct costs do not need cost driversDirect costs do not need cost drivers  They are themselves cost drivers since they canThey are themselves cost drivers since they can be traced directly to a product.be traced directly to a product.  All other factory or manufacturing costs needAll other factory or manufacturing costs need cost drivers.cost drivers.
  4. 4. COST DRIVERS – WHY?COST DRIVERS – WHY?  They are the links between a pool of costs in anThey are the links between a pool of costs in an activity centre and the productactivity centre and the product  Therefore in order to trace overhead costs toTherefore in order to trace overhead costs to products, appropriate cost drivers should beproducts, appropriate cost drivers should be identified.identified.
  5. 5. COST DRIVER - TYPESCOST DRIVER - TYPES There are two categories of cost driver:There are two categories of cost driver:  Resource Cost Driver: A measure of theResource Cost Driver: A measure of the quantity of resources consumed by an activity.quantity of resources consumed by an activity. Used to assign the cost of a resource to anUsed to assign the cost of a resource to an activity or cost pool.activity or cost pool.  Activity Cost Driver: Measure of the frequencyActivity Cost Driver: Measure of the frequency and intensity of demand, placed on activities byand intensity of demand, placed on activities by cost objects. Used to assign activity costs to costcost objects. Used to assign activity costs to cost objects.objects.
  6. 6. ACTIVITIES & COST DRIVERSACTIVITIES & COST DRIVERS FUNCTIONAL AREAS ACTIVITIES SUITABLE COST DRIVERS Materials Management • Issue of purchase orders • Number of purchase orders • Inspection of materials • Number of purchase orders Stores Management • Storing of materials • Value of materials stored • Servicing of requisitions • Number of requisitions • Inspection & Verification • Number of times inspected • Stock Taking • Value of stock Quality Control • Testing of Samples • Number of batches produced Marketing • Demand Creation • Increase in sales • Advertising • Increase in sales • Despatches •Number of orders
  7. 7. ACTIVITIES & COST DRIVERSACTIVITIES & COST DRIVERS FUNCTIONAL AREAS ACTIVITIES SUITABLE COST DRIVERS Personnel Management • Recruitment of employees • Number of employees recruited • Maintenance of leave records & attendance • Number of employees Research & Development • Research • Number of research Projects Machining • Setup Cost • Number of production runs • Power cost •Machine hours
  8. 8. ACTIVITIES-CLASSIFICATIONACTIVITIES-CLASSIFICATION In manufacturing organizations, activities areIn manufacturing organizations, activities are grouped on the basis of different levels at whichgrouped on the basis of different levels at which activities are performed and hence are identifiedactivities are performed and hence are identified and classified into broadly four differentand classified into broadly four different categories:categories:
  9. 9. UNIT LEVEL ACTIVITIESUNIT LEVEL ACTIVITIES  Activities performed each time a unit isActivities performed each time a unit is produced.produced.  They are repetitive activitiesThey are repetitive activities  Example: Direct labour hours, Machine hours,Example: Direct labour hours, Machine hours, Power are used each time a unit is producedPower are used each time a unit is produced  Costs of unit level activities vary with theCosts of unit level activities vary with the number of units producednumber of units produced
  10. 10. BATCH LEVEL ACTIVITIESBATCH LEVEL ACTIVITIES  Activities performed each time a batch of goodsActivities performed each time a batch of goods or products is producedor products is produced  Costs of batch level activities vary with theCosts of batch level activities vary with the number of batches but are fixed with respect tonumber of batches but are fixed with respect to the number of units in each batchthe number of units in each batch  Example: Machine setups, inspections,Example: Machine setups, inspections, production scheduling, materials handlingproduction scheduling, materials handling
  11. 11. PRODUCT LEVEL ACTIVITIESPRODUCT LEVEL ACTIVITIES  Activities performed to support the productionActivities performed to support the production of each different type of productof each different type of product  Example: Maintenance of equipment,Example: Maintenance of equipment, engineering charges, testing routines,engineering charges, testing routines, maintaining bills of materialsmaintaining bills of materials
  12. 12. FACILITY LEVEL ACTIVITIESFACILITY LEVEL ACTIVITIES  Activities needed to sustain a factory’s generalActivities needed to sustain a factory’s general manufacturing processmanufacturing process  These are common to a variety of productsThese are common to a variety of products  Most difficult to link to product specificMost difficult to link to product specific activitiesactivities  Examples: Factory management, maintenance,Examples: Factory management, maintenance, security, plant depreciationsecurity, plant depreciation
  13. 13. EXAMPLESEXAMPLES Examples of costs driven by activities at each level:Examples of costs driven by activities at each level: ACTIVITY LEVEL EXAMPLES OF ACTIVITY COST 1. Unit Level • Cost of raw materials • Cost of inserting a component • Utilities cost of operating equipment • Some costs of packaging • Sales Commissions 2. Batch Level • Cost of processing sales order • Cost of issuing and tracking work order • Cost of equipment setup • Cost of moving batch between workstations • Cost of inspection (assuming same number of units inspected in each batch)
  14. 14. EXAMPLES…EXAMPLES… ACTIVITY LEVEL EXAMPLES OF ACTIVITY COST 3. Product Level • Cost of Product Development • Cost of Product marketing such as advertising • Cost of specialized equipment • Cost of maintaining specialized equipment 4. Facility Level • Cost of maintaining general facilities such as buildings and grounds • Cost of non-specialized equipment • Cost of maintaining non-specialized equipment • Cost of real property taxes • Cost of general advertising • Cost of general administration such as the plant manager’s salary
  15. 15. COST BEHAVIOURCOST BEHAVIOUR
  16. 16. COST - CLASSIFICATIONCOST - CLASSIFICATION Costs can be classified into fixed, variable andCosts can be classified into fixed, variable and Semi-variable costs on the basis of:Semi-variable costs on the basis of:  VariabilityVariability  Changes in cost behaviour in relation to changeChanges in cost behaviour in relation to change in output, activity or volume where activity mayin output, activity or volume where activity may be indicated in any form such as units of output,be indicated in any form such as units of output, hours worked, sales etc.hours worked, sales etc.
  17. 17. FIXED COSTFIXED COST  Cost which does not change for a given periodCost which does not change for a given period of time despite wide fluctuations in output orof time despite wide fluctuations in output or volume of activityvolume of activity  Also known as standby costs, Capacity costs orAlso known as standby costs, Capacity costs or Period Costs.Period Costs.  Accrues with the passage of time and not withAccrues with the passage of time and not with the production of the product or the job, whichthe production of the product or the job, which is why they are expressed in time such as per dayis why they are expressed in time such as per day per month and not in terms of unitper month and not in terms of unit  Examples: Rent, Property Taxes, advertising etc.Examples: Rent, Property Taxes, advertising etc.
  18. 18. CHANGES IN FIXED COSTSCHANGES IN FIXED COSTS  Fixed costs remain fixed only in the short runFixed costs remain fixed only in the short run and so it is improper to say Fixed Costs do notand so it is improper to say Fixed Costs do not change.change.
  19. 19. CHANGES IN FIXED COSTCHANGES IN FIXED COST  Between 20,000 & 80,000 units of production, fixed cost is Rs.Between 20,000 & 80,000 units of production, fixed cost is Rs. 50,00050,000  In excess of 80,000 units, fixed cost becomes Rs. 60,000. ThisIn excess of 80,000 units, fixed cost becomes Rs. 60,000. This assumes that increase in production after a certain level requiresassumes that increase in production after a certain level requires increase in fixed expenses such as additional supervision,increase in fixed expenses such as additional supervision, increase in quality control costs.increase in quality control costs.
  20. 20. CHANGES IN FIXED COSTCHANGES IN FIXED COST  Between 20,000 & 80,000 units of production, fixed cost is Rs.Between 20,000 & 80,000 units of production, fixed cost is Rs. 50,00050,000  From 0 units (shut down) to 20,000 units, fixed cost is Rs.From 0 units (shut down) to 20,000 units, fixed cost is Rs. 25,000. If the level of activity comes to less than 20,000 units25,000. If the level of activity comes to less than 20,000 units some fixed costs may not be incurred such as costs onsome fixed costs may not be incurred such as costs on accounting functions, supplies, staff and so on.accounting functions, supplies, staff and so on.
  21. 21. EXAMPLEEXAMPLE  Costs of testing personal computers may notCosts of testing personal computers may not change with a change in the volume ofchange with a change in the volume of production and would be fixed in the short run.production and would be fixed in the short run.  In the long run organization may need toIn the long run organization may need to increase/ decrease testing department’sincrease/ decrease testing department’s equipment & staff to the levels needed toequipment & staff to the levels needed to support future production volumes .support future production volumes .  So in the long run, volume of production orSo in the long run, volume of production or activity becomes cost drivers of these testing &activity becomes cost drivers of these testing & staff costs.staff costs.
  22. 22. FIXED COST-CLASSIFICATIONFIXED COST-CLASSIFICATION 1.1. Committed costs: Incurred to maintainCommitted costs: Incurred to maintain Company’s facilities & physical existence.Company’s facilities & physical existence. Management has little or no discretion.Management has little or no discretion. Examples: Plant & equipment depreciation,Examples: Plant & equipment depreciation, taxes, insurance premium rate, rent charges etc.taxes, insurance premium rate, rent charges etc. 2.2. Managed Costs: Related to current operations.Managed Costs: Related to current operations. Paid to ensure the continued operating existencePaid to ensure the continued operating existence of the company. Example: Management & Staffof the company. Example: Management & Staff salariessalaries
  23. 23. FIXED COST-CLASSIFICATIONFIXED COST-CLASSIFICATION 3. Discretionary costs: Result from special policy3. Discretionary costs: Result from special policy decisions, management programmes, newdecisions, management programmes, new researches etc. Example: R&D Costs, Marketingresearches etc. Example: R&D Costs, Marketing Programmes, new system development costs.Programmes, new system development costs. 4. Step Costs: Constant for a given amount of4. Step Costs: Constant for a given amount of output and then increases in a fixed amountoutput and then increases in a fixed amount after a higher output level.after a higher output level.
  24. 24. STEP COSTS - EXAMPLESTEP COSTS - EXAMPLE In a manufacturing Company:In a manufacturing Company:  One supervisor required at a salary of Rs. 10,000 p.m. for every 50One supervisor required at a salary of Rs. 10,000 p.m. for every 50 workers.workers.  As soon as 51As soon as 51stst worker is employed, cost of supervision increases to Rs.worker is employed, cost of supervision increases to Rs. 20,00020,000  Cost of supervision will go up if more than 100 workers are working.Cost of supervision will go up if more than 100 workers are working.
  25. 25. VARIABLE COSTVARIABLE COST  Costs which vary directly or proportionatelyCosts which vary directly or proportionately with the output.with the output.  Direct materials cost & direct labour cost are theDirect materials cost & direct labour cost are the costs which are generally variablecosts which are generally variable  Total variable costs change as more units areTotal variable costs change as more units are produced, per unit variable cost remainsproduced, per unit variable cost remains constantconstant  Example: factory supplies, indirect materials,Example: factory supplies, indirect materials, sales commission, office suppliessales commission, office supplies
  26. 26. VARIABLE COSTVARIABLE COST  If a factory is shut down, variable costs areIf a factory is shut down, variable costs are eliminatedeliminated  Expressed in terms of units or percentage ofExpressed in terms of units or percentage of volumevolume  Cannot be stated in terms of timeCannot be stated in terms of time
  27. 27. VARIABLE COST-BEHAVIOURVARIABLE COST-BEHAVIOUR  Behaviour pattern of direct material costBehaviour pattern of direct material cost  For every increase in units produced, there is a proportionateFor every increase in units produced, there is a proportionate increase in costsincrease in costs  Cost of direct materials increases at a constant rate of Rs. 50 perCost of direct materials increases at a constant rate of Rs. 50 per unit.unit.
  28. 28. VARIABLE COST – LINEAR?VARIABLE COST – LINEAR?  Variable cost may be linear only over the normalVariable cost may be linear only over the normal range of activity levelsrange of activity levels  Beyond the normal range of activity, variableBeyond the normal range of activity, variable cost per unit may show non-linear or curvi-linearcost per unit may show non-linear or curvi-linear line implying variable costs are not varying inline implying variable costs are not varying in direct proportion to output or activity changesdirect proportion to output or activity changes
  29. 29. VARIABLE COST - CONVEXVARIABLE COST - CONVEX  Where each extra unit of output causes a lessWhere each extra unit of output causes a less than proportionate increase in cost i.e.,than proportionate increase in cost i.e., economies of scale operateeconomies of scale operate
  30. 30. VARIABLE COST - CONCAVEVARIABLE COST - CONCAVE  Where each extra unit of output causes a moreWhere each extra unit of output causes a more than proportionate increase in cost i.e.,than proportionate increase in cost i.e., diminishing returns operatediminishing returns operate
  31. 31. VARIABLE COST–CURVIVARIABLE COST–CURVI LINEAR ?LINEAR ?  In some production process, the amount ofIn some production process, the amount of waste materials remain more & more constantwaste materials remain more & more constant  So when production increases, unit variable costSo when production increases, unit variable cost for material decreases due to economies of scalefor material decreases due to economies of scale On the other hand:On the other hand:  Diminishing returns will operate when itDiminishing returns will operate when it becomes necessary to pay increasing differentialbecomes necessary to pay increasing differential piece rates to increase productionpiece rates to increase production  A form of concave curvi–linear relationship willA form of concave curvi–linear relationship will emerge.
  32. 32. MIXED COSTMIXED COST  Combination of semi-variable and semi fixedCombination of semi-variable and semi fixed costs.costs.  Because of variable component – fluctuate withBecause of variable component – fluctuate with volumevolume  Because of fixed component – do not change inBecause of fixed component – do not change in direct proportion to output.direct proportion to output.
  33. 33. SEMI-FIXED COSTSSEMI-FIXED COSTS  Costs which remain constant upto a certain levelCosts which remain constant upto a certain level of output after which they become variable.of output after which they become variable.
  34. 34. SEMI-VARIABLE COSTSSEMI-VARIABLE COSTS  Cost is basically variable but whose slope mayCost is basically variable but whose slope may change abruptly when a certain output level ischange abruptly when a certain output level is reached.reached.
  35. 35. MIXED COSTSMIXED COSTS  Mathematically mixed costs can be expressed asMathematically mixed costs can be expressed as follows:follows:
  36. 36. EXAMPLEEXAMPLE  Worker is paid a salary of Rs. 1500 per weekWorker is paid a salary of Rs. 1500 per week (fixed) plus a bonus of Re 1 for each unit(fixed) plus a bonus of Re 1 for each unit completed (variable). If he increases his weeklycompleted (variable). If he increases his weekly output from 1000 units to 1500 units what is theoutput from 1000 units to 1500 units what is the effect on his earnings?effect on his earnings? Units produced 1,000 1,500 Fixed Component Rs. 1,500 Rs. 1,500 Variable Component Rs. 1,000 Rs 1,500 Total Rs. 2,500 Rs. 3,000
  37. 37. THANK YOUTHANK YOU

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