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Identify Cost Drivers
How does a company determine its cost drivers for indirect materials, indirect labor, and other overhead
costs? To begin the determination of appropriate cost drivers, an accountant analyzes the activities in the
product production process that contribute to the cost of that product. An activity is any action that consumes
company resources, such as taking orders for a product, setting up machines to produce the product,
inspecting the product, and providing customer support before and through the order process. For example,
Musicality’s direct costs can be traced to the products, but there are indirect costs associated with using
various types of material for each product. While the Orchestra product has more intricate materials and labor,
it has fewer costs associated with requisitioning and conveying materials to the production line than the other
products have. Additionally, examining the inspection costs indicates the Orchestra product is a simple
product to inspect, so random quality inspections are sufficient. But individual inspections for both the Solo
and Band products are critical, and the overhead related to inspection costs should be based on the number of
inspections.
As you can imagine, the unique aspects of the production process for each product affect the overhead cost of
each product. However, these costs may not be allocated to the products appropriately when overhead is
applied using a predetermined rate based on one activity. While Solo, Band, and Orchestra might appear to be
different only in quality, they are actually very different from each other when it comes to manufacturing
overhead costs.
Whether the products produced require significantly different overhead resources or not, the company
benefits from understanding what its cost drivers are. The more efficiently each product’s activities are
tracked, the more actual cost drivers are discovered, and the more accurately overhead can be assigned to
each product.
C O N C E P T S I N P R A C T I C E
Cost Drivers for Small Businesses
The value of analyzing cost drivers can be used in budgeting beyond allocating overhead to products.
American Express has forums designed to help small businesses be successful. Knowing the cost drivers
for your business can help with budgeting. American Express states that all business activities are related
to five main cost drivers:[4]
• Employee head count is often the driver for office supply expense.
• Salesperson head count is often the driver for auto and other employee travel expense.
• The number of leads required to reach the target sales goal is often the driver for advertising, public
relations, social media, search engine optimization expense, and other expenses associated with
generating leads.
• Sales and all related variable expenses are often the driver for commissions, bad debt, insurance
expense, and so on.
• Fixed costs, such as postage, web hosting fees, business licenses, and banking fees, are often
overlooked as cost drivers.
4 American Express. “5 Cost Drivers to Help You Make Accurate Expense Projections.” June 23, 2011. https://www.americanexpress.com/us/
small-business/openforum/articles/5-cost-drivers-to-help-you-make-accurate-expense-projections/
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6.3 Calculate Activity-Based Product Costs
As technology changes the ratio between direct labor and overhead, more overhead costs are linked to drivers
other than direct labor and machine hours. This shift in costs gives companies the opportunity to stop using
the traditional single predetermined overhead rate applied to all units of production and instead use an
overhead allocation approach based on the actual activities that drive overhead. Making this change allows
management to obtain more accurate product cost information, which leads to more informed decisions.
Activity-based costing (ABC) is the process that assigns overhead to products based on the various activities
that drive overhead costs.
Historical Perspective on Determination of Manufacturing Overhead Allocation
All products consist of material, labor, and overhead, and the major cost components have historically been
materials and labor. Manufacturing overhead was not a large cost of the product, so an overhead allocation
method based on labor or machine hours was logical. For example, as shown in Figure 6.3, Musicality
determined the direct costs and direct labor for their three products: Solo, Band, and Orchestra. Under the
traditional method of costing, the predetermined overhead rate of $2 per direct labor hour was computed by
dividing the estimated overhead by the estimated direct labor hours. Based on the number of direct labor
hours and the number of units produced for each product, the overhead per product is shown in Figure 6.4.
As technology costs decreased and production methods became more efficient, overhead costs changed and
became a much larger component of product costs. For many companies, and in many cases, overhead costs
are now significantly larger than labor costs. For example, in the last few years, many industries have
increased technology, and the amount of overhead has doubled.[5] Technology has changed the
manufacturing labor force, and therefore, the type and cost of labor associated with those jobs have changed.
In addition, technology has made it easier to track the various activities and their related overhead costs.
Costs can be gathered on a unit level, batch level, product level, or factory level. The idea behind these various
levels is that at each level, there are additional costs that are encountered, so a company must decide at which
level or levels it is best for the company to accumulate costs. A unit-level cost is incurred each time a unit of
product is produced and includes costs such as materials and labor. A batch-level cost is incurred every time
a batch of items is manufactured, for example, costs associated with purchasing and receiving materials. A
product-level cost is incurred each time a product is produced and includes costs such as engineering costs,
testing costs, or quality control costs. A factory-level cost is incurred because products are being produced
and includes costs such as the plant supervisor’s salary and rent on the factory building. By definition, indirect
labor is not traced to individual products. However, it is possible to track some indirect labor to several jobs or
batches. A similar amount of information can be derived for indirect material. An example of an indirect
material in some manufacturing processes is cleaning solution. For example, one type of cleaning solution is
used in the manufacturing of pop sockets. It is not practical to measure every ounce of cleaning solution used
in the manufacture of an individual pop socket; rather, it makes sense to allocate to a particular batch of pop
5 Mary Ellen Biery. “A Sure-Fire Way to Boost the Bottom Line.” Forbes. January 12, 2014. https://www.forbes.com/sites/sageworks/2014/01/
12/control-overhead-compare-industry-data/#47a9ea69d068
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sockets the cost of the cleaning solution needed to make that batch. Likewise, a manufacturer of frozen french
fries uses a different type of solution to clean potatoes prior to making the french fries and would allocate the
cost of the solution based on how much is used to make each batch of fries.
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Establishing an Activity-Based Costing System
ABC is a five-stage process that allocates overhead more precisely than traditional allocation does by applying
it to the products that use those activities. ABC works best in complex processes where the expenses are not
driven by a single cost driver. Instead, several cost drivers are used as the overhead costs are analyzed and
grouped into activities,and each activity is allocated based on each group’s cost driver. The five stages of the
ABC process are:
1. Identify the activities performed in the organization
2. Determine activity cost pools
3. Calculate activity rates for each cost pool
4. Allocate activity rates to products (or services)
5. Calculate unit product costs
The first step is to identify activities needed for production. An activity is an action or process involved in the
production of inventory. There can be many activities that consume resources, and management will need to
narrow down the activities to those that have the biggest impact on overhead costs. Examples of these
activities include:
• Taking orders
• Setting up machines
• Purchasing material
• Assembling products
• Inspecting products
• Providing customer service
The second step is assigning overhead costs to the identified activities. In this step, overhead costs are
assigned to each of the activities to become a cost pool. A cost pool is a list of costs incurred when related
activities are performed. Table 6.2 illustrates the various cost pools along with their activities and related costs.
Cost Pools and Their Activities and Related Costs
Cost Pool Activities and Related Costs
Production • Indirect labor setting up machines
• Indirect labor cost of accepting and verifying orders
• Machine maintenance costs
• Costs to operate the machine: utilities, insurance, etc.
Purchasing material • Preparing purchase requisitions for the material
• Cost to move material from receiving department into production
• Depreciation of equipment used to move material
Inspect products • Inspection supervisor costs
• Cost to move product to and from the inspection area
Table 6.2
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Cost Pools and Their Activities and Related Costs
Cost Pool Activities and Related Costs
Assemble products • Cost of assembly machine
• Cost of label machine
• Cost of labels
Technological production • Website maintenance
• Depreciation of computers
Table 6.2
For example, the production cost pool consists of costs such as indirect labor for those accepting the order,
verifying the customer has credit to pay for the order, maintenance and depreciation on the machines used to
produce the orders, and utilities and rent for operating the machines. Figure 6.8 illustrates how the costs in
each pool are allocated to each product in a different proportion.
Figure 6.8 Allocating Overhead by Cost Pool. (attribution: Copyright Rice University, OpenStax, under CC BY-
NC-SA 4.0 license)
Once the costs are grouped into similar cost pools, the activities in each pool are analyzed to determine which
activity “drives” the costs in that pool, leading to the third step of ABC: identify the cost driver for each cost
pool and estimate an annual level of activity for each cost driver. As you’ve learned, the cost driver is the
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	Chapter 6. Activity-Based, Variable, and Absorption Costing
	6.3. Calculate Activity-Based Product Costs*