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COST DRIVERS

&
COST BEHAVIOUR
Dr. Rana Singh
www.ranasingh.org

COST DRIVER - DEFINITION

An activity which generates cost


A factor such as the level of activity or volume
that causally affects cost.
Existence of a cause-and-effect relationship
between a change in the level of activity or
volume and change in the level of total costs of
that cost object.
Thus cost drivers signify factors, forces or
events that determine the costs of activities

COST DRIVER - IDENTIFIED

Direct costs do not need cost drivers


They are themselves cost drivers since they can
be traced directly to a product.
All other factory or manufacturing costs need
cost drivers.

COST DRIVERS WHY?

They are the links between a pool of costs in an


activity centre and the product
A pool of
costs

COST
DRIVERS

Product

Therefore in order to trace overhead costs to


products, appropriate cost drivers should be
identified.

COST DRIVER - TYPES


There are two categories of cost driver:
Resource Cost Driver: A measure of the
quantity of resources consumed by an activity.
Used to assign the cost of a resource to an
activity or cost pool.
Activity Cost Driver: Measure of the frequency
and intensity of demand, placed on activities by
cost objects. Used to assign activity costs to cost
objects.

ACTIVITIES & 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

ACTIVITIES & 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

ACTIVITIES-CLASSIFICATION
In manufacturing organizations, activities are
grouped on the basis of different levels at which
activities are performed and hence are identified
and classified into broadly four different
categories:
Unit
Batch
Level
Activities

Level
Activities

Product
Level
Activities

Facility
Level
Activities

UNIT LEVEL ACTIVITIES

Activities performed each time a unit is


produced.
They are repetitive activities
Example: Direct labour hours, Machine hours,
Power are used each time a unit is produced
Costs of unit level activities vary with the
number of units produced

BATCH LEVEL ACTIVITIES

Activities performed each time a batch of goods


or products is produced
Costs of batch level activities vary with the
number of batches but are fixed with respect to
the number of units in each batch
Example:
Machine
setups,
inspections,
production scheduling, materials handling

PRODUCT LEVEL ACTIVITIES

Activities performed to support the production


of each different type of product
Example:
Maintenance
of
equipment,
engineering
charges,
testing
routines,
maintaining bills of materials

FACILITY LEVEL ACTIVITIES

Activities needed to sustain a factorys general


manufacturing process
These are common to a variety of products
Most difficult to link to product specific
activities
Examples: Factory management, maintenance,
security, plant depreciation

EXAMPLES
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)

EXAMPLES
ACTIVITY LEVEL

EXAMPLES OF ACTIVITY COST

3. Product Level

Cost of
Cost of
Cost of
Cost of

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
managers salary

Product Development
Product marketing such as advertising
specialized equipment
maintaining specialized equipment

COST BEHAVIOUR

COST - CLASSIFICATION

Costs can be classified into fixed, variable and


Semi-variable costs on the basis of:
Variability
Changes in cost behaviour in relation to change
in output, activity or volume where activity may
be indicated in any form such as units of output,
hours worked, sales etc.

FIXED COST

Cost which does not change for a given period


of time despite wide fluctuations in output or
volume of activity
Also known as standby costs, Capacity costs or
Period Costs.
Accrues with the passage of time and not with
the production of the product or the job, which
is why they are expressed in time such as per day
per month and not in terms of unit
Examples: Rent, Property Taxes, advertising etc.

CHANGES IN FIXED COSTS


Fixed costs remain fixed only in the short run
and so it is improper to say Fixed Costs do not
change.
FIXED COST
120,000
100,000

Total Cost
Rs. 1,00,000

80,000
60,000
40,000

20,000
0
0

20
40
Volume (In Thousands)

60

Fixed Cost (Rs.)

CHANGES IN FIXED COST


70,000
60,000
50,000
40,000
30,000
20,000
10,000
0

20

40

60

80

100

Relevant Range or volume


Production Units (In Thousands)

Between 20,000 & 80,000 units of production, fixed cost is Rs.


50,000
In excess of 80,000 units, fixed cost becomes Rs. 60,000. This
assumes that increase in production after a certain level requires
increase in fixed expenses such as additional supervision,
increase in quality control costs.

Fixed Cost (Rs.)

CHANGES IN FIXED COST


70,000
60,000
50,000
40,000
30,000
20,000
10,000
0

20

40

60

80

100

Relevant Range or volume


Production Units (In Thousands)

Between 20,000 & 80,000 units of production, fixed cost is Rs.


50,000
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 units
some fixed costs may not be incurred such as costs on
accounting functions, supplies, staff and so on.

EXAMPLE

Costs of testing personal computers may not


change with a change in the volume of
production and would be fixed in the short run.
In the long run organization may need to
increase/ decrease testing departments
equipment & staff to the levels needed to
support future production volumes .
So in the long run, volume of production or
activity becomes cost drivers of these testing &
staff costs.

FIXED COST-CLASSIFICATION
1.

2.

Committed costs: Incurred to maintain


Companys facilities & physical existence.
Management has little or no discretion.
Examples: Plant & equipment depreciation,
taxes, insurance premium rate, rent charges etc.
Managed Costs: Related to current operations.
Paid to ensure the continued operating existence
of the company. Example: Management & Staff
salaries

FIXED COST-CLASSIFICATION
3. Discretionary costs: Result from special policy
decisions, management programmes, new
researches etc. Example: R&D Costs, Marketing
Programmes, new system development costs.
4. Step Costs: Constant for a given amount of
output and then increases in a fixed amount
after a higher output level.

STEP COSTS - EXAMPLE

In a manufacturing Company:
One supervisor required at a salary of Rs. 10,000 p.m. for every 50
workers.
As soon as 51st worker is employed, cost of supervision increases to
Rs. 20,000
Cost of supervision will go up if more than 100 workers are working.

VARIABLE COST

Costs which vary directly or proportionately


with the output.
Direct materials cost & direct labour cost are the
costs which are generally variable
Total variable costs change as more units are
produced, per unit variable cost remains
constant
Example: factory supplies, indirect materials,
sales commission, office supplies

VARIABLE COST

If a factory is shut down, variable costs are


eliminated
Expressed in terms of units or percentage of
volume
Cannot be stated in terms of time

VARIABLE COST-BEHAVIOUR
Behaviour pattern of direct material cost
Total Direct Material
Cost (Rs.)

300,000
250,000
200,000
150,000
100,000
50,000
0
0

1000

2000
3000
4000
Production Units

5000

6000

For every increase in units produced, there is a proportionate


increase in costs
Cost of direct materials increases at a constant rate of Rs. 50 per
unit.

VARIABLE COST LINEAR?

Variable cost may be linear only over the normal


range of activity levels
Beyond the normal range of activity, variable
cost per unit may show non-linear or curvilinear line implying variable costs are not varying
in direct proportion to output or activity
changes

Cost

VARIABLE COST - CONVEX


200,000

Convex

150,000
100,000
50,000
0

1000

2000

3000

4000

5000

6000

Level of Activity

Where each extra unit of output causes a less


than proportionate increase in cost i.e.,
economies of scale operate

Cost

VARIABLE COST - CONCAVE


350,000
300,000
250,000
200,000
150,000
100,000
50,000
0

Concave

1000

2000

3000

4000

Level of Activity

Where each extra unit of output causes a more


than proportionate increase in cost i.e.,
diminishing returns operate

VARIABLE COSTCURVI
LINEAR ?
In some production process, the amount of
waste materials remain more & more constant
So when production increases, unit variable cost
for material decreases due to economies of scale
On the other hand:
Diminishing returns will operate when it
becomes necessary to pay increasing differential
piece rates to increase production
A form of concave curvilinear relationship will
emerge.

MIXED COST

Combination of semi-variable and semi fixed


costs.
Because of variable component fluctuate with
volume
Because of fixed component do not change in
direct proportion to output.

SEMI-FIXED COSTS
Costs which remain constant upto a certain level
of output after which they become variable.
60,000

Total Costs (Rs.)

50,000
40,000
30,000
20,000
10,000
0
0

1000

2000 3000 4000


Units produced

5000

6000

SEMI-VARIABLE COSTS
Cost is basically variable but whose slope may
change abruptly when a certain output level is
reached. 30,000
Total Costs (Rs.)

25,000
20,000

15,000
10,000

5,000
0

1000

2000 3000 4000


Units Produced

5000

MIXED COSTS

Mathematically mixed costs can be expressed as


follows:
Total Fixed
Cost

Total
Mixed
Cost
Units x
variable
cost per
unit

EXAMPLE

Worker is paid a salary of Rs. 1500 per week


(fixed) plus a bonus of Re 1 for each unit
completed (variable). If he increases his weekly
output from 1000 units to 1500 units what is the
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. 3,000

Rs. 2,500

THANK YOU

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