Cost Drivers

The Third Key to Strategic

Cost Management

Basic Definitions on Cost

A cost is incurred when a firm uses a resource for some purpose

Costs are assembled into meaningful groups called cost pools

(e.g., by type of cost or source)

Any factor that has the effect of changing the level of total cost
is called a cost driver

A cost object is any product, service, customer, activity, or

organizational unit to which costs are assigned for some
management purpose
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Cost Assignment: General Principles

Costs
Electric Motor
Materials
Handling

Cost Drivers and Cost Assignment

Cost Pools

Cost Objects

Assembly

Dishwasher

Packing

Washing
Machine

Supervision
Packing
Materials
Final
Inspection
Blocher,Stout,Cokins,Chen, Cost Management 4e

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Basic Purposes of Cost

For product and service costing

For strategic decision-making (cost-driver analysis)

For planning and decision-making

For control/feedback

Blocher,Stout,Cokins,Chen, Cost Management 4e

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Product/Service Costing
The process of assigning costs to cost pools or from cost
pools to cost objects
Direct

costs can be conveniently and economically traced to

a cost pool or a cost object

Indirect

costs cannot be traced conveniently or economically

to a cost pool or a cost object

Because

indirect costs cannot be traced, assignment is made

through the use of cost drivers (cost allocation)

These

cost drivers are often called allocation bases

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Product and Service Costing Concepts

Product

costs include only the costs necessary to

complete the product at the manufacturing step in the
value chain (manufacturing) or to purchase and
transport the product to the location of sale
(merchandising)

Period

costs include all other costs incurred by the firm

in managing or selling the product (indirect costs
outside the manufacturing step of the value chain)
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Costs for Strategic Decision-Making Cost driver

Analysis

Cost drivers provide two roles for the management

accountant
Assigning

costs to cost objects

Explaining

cost behavior, i.e., how total cost changes as the cost

driver changes

Blocher,Stout,Cokins,Chen, Cost Management 4e

The McGraw-Hill Companies 2008

Types of Cost Drivers

The

four types of cost drivers:

Volume-based

cost drivers,

Activity-based

cost drivers,

Structural

cost drivers, and

Executional

cost drivers.

Blocher,Stout,Cokins,Chen, Cost Management 4e

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 Activity-based

drivers are developed at a detailed level of operations

and are associated with a given manufacturing activity. Activity-based
cost drivers are identified by using activity analysis, a detailed
description of the specific activities performed in the firms operations.

Volume-based

cost drivers are developed at an aggregate level. The

relationship between the cost driver and total cost is approximately
linear within the relevant range.

Cost

concept relating to the volume based:

Fixed

Vs. Variable, Average cost Vs. Marginal cost, CVP analysis, Break even
Analysis etc.

Volume

based cost drivers capture very little of richness of cost

behavior.
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Drawbacks of volume based cost drivers

Ignores the fact that different products make different demands on factory support
services. It not relate to unique manufacturing characteristics in different
operations

As absorption costing emphasized on total cost namely both variable and fixed, it is
not so useful for management to use to make decision, planning and control.

It only uses a common plant wide or departmental cost driver and ignores
differences in activities for different products or productions runs with in the plant.

Employs

common

activity

volume

of

all

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products

Structural and executional drivers

Structural

and executional drivers involve strategic and

operational decisions that affect the relationship between these
cost drivers and total cost.

Structural

cost drivers facilitate strategic decision making

because they involve plans and decisions that have long-term
effects.

It

involves choices by the firm that drive product cost

Scale,

experience, technology, and complexity are considered in

hopes of improving competitive position

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Executional cost drivers facilitate operational decision making

by focusing on short-term effects.

Those determinants of a firms cost position that hinge on its

ability to execute successfully. (Related to organizational skills)

Workforce involvement, design of the production process, and supplier

relationships are considered in an attempt to reduce costs

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Structural Cost Drivers

Scale:

Investment size in manufacturing, R&D, and

marketing
Scope: Degree of vertical integration
Experience: Previous repetitions of current work
Technology: Process technologies used at each step in
value chain
Complexity: Broadness of product line

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Executional Cost Drivers

Work

Force Involvement: participation; empowerment;

commitment to continuous improvement
Capacity Utilization: given scale choices on plant
construction
Plant Layout Efficiency: compared to current norms
Product Configuration: design or formulation effectiveness
Exploiting Linkages with Suppliers/Customers: in relation
to the value chain

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Cost Driver Analysis Some Key Ideas

Volume is usually not the best way to explain cost behavior

More useful to explain cost position in terms of structural choices and

executional skills

Not all strategic cost drivers applicable or equally important all the time but
some are probably very important in every instance.

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Blocher,Stout,Cokins,Chen, Cost Management 4e

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Cost Driver Analysis

Management Accounting

Strategic Cost management

What is the most

useful way to analyze
costs?

In terms of products, customers,

functions

In terms of various stages of the overall

value chain of which the firm is a part

Strongly internal focus

Strongly external focus

What is the objective

of cost analysis?

Not regard to the strategic

context

Design of cost management system

changes dramatically depending on the
basic strategic positioning of the firm

Score keeping, Problem solving,

attention direction
How should we try to
understand cost
behavior?

Cost is primarily a function of

output volume

Cost is a function of strategic choices

about the structure of how to compete
and managerial skill in executing the
strategic choices.

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Linkages Among Value Chain Analysis, Strategic

Positioning Analysis and Cost Driver Analysis

Understanding the value chain helps define the optimal

positioning strategy

Understanding the value chain and positioning strategy helps

identify the relevant cost drivers

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