How an Activity Cost Driver Analysis Works

Activities that result in variable costs are known as activity cost drivers. More than one operation cost driver can be included in a single variable expense. Machine and labor hours, for instance, are operation cost factors in the production of a product. Furthermore, a company can break down all variable costs and examine one or more operation cost generators affected by various variables.

If the minimum wage rises, for example, the cost of manufacturing a product will rise as well. An ABC system acknowledges the relationship between prices, overhead operations, and produced goods. The system then assigns indirect costs to products more arbitrarily than conventional approaches because of this relationship. When analyzing activity cost drivers, you should consider particular factors such as cause-and-effect relationships between drivers and cost objects. You also need to be aware of whether the possibility of certain drivers is easier to calculate and if certain activities are more expensive.

Finally, activity cost analysis helps management assess alternative activity drivers that could be more cost-effective in machine hours, human resources, materials, etc. Management can gain a greater understanding of a company's costs by looking at activity cost drivers. Companies may help minimize or remove needless expenditures by identifying the precise cause of various expenses. Comparing the costs of various goods and services can be meaningless if a company does not properly allocate the cost drivers.

Example of Activity Cost Driver Analysis

Imagine for every 200 bags of chips sold your chips company needs to clean the chip frying machine. To figure out the cost driver (the number of bags sold), you will have to run an activity cost analysis. This analysis will show you how much each activity costs your company, including the amount it will cost you to clean the chip frying machine. So, if it'll cost your company $50 to clean the fryer after you sell every 200 bags, then your analysis will also show the activity-based cost.

As a result of the cost for cleaning, your activity cost analysis will reveal that each bag of chips sold results in an activity cost of 25 cents ($50 / 200 bags of chips). Your analysis will combine the operation expense driver with other drivers to determine your business's margin on its bags of chips. When it comes to expense projections, activity cost driver analysis is very crucial.

Suppose your business management receives a sales order for a certain number of chip bag units, for example. In that case, management will calculate precisely how much it would cost to fulfill that order. The process of calculating the financial implication of supplying your customer's order is an activity cost analysis. This calculation will also help you know how much profit you'll likely make from fulfilling the customer's orders.