Cost Drivers and Its HierarchiesThe most basic cost driver is customer demand. Without customer demand for products or services, the organization cannot exist. To serve customers, managers and employees make a variety of decisions and take numerous actions. These decisions and actions—undertaken to satisfy customer demand—drives costs. An activity is a unit of work. To serve a customer at a restaurant, for example, a waiter or waitress might perform the following units of work: seat customer and offer menu, take customer order, send order to kitchen, bring food to customer, serve and replenish beverages, determine and bring bill to customer, collect money and give change, clear and reset table. Each of these is an activity, and the performance of each activity consumes resources that cost money.

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To manage activities and their costs, it is necessary to understand how costs respond to cost drivers, which are the factors that cause or influence costs.

 

While these cost drivers may be classified in a variety of ways, I believe that dividing them into the three categories of structural, organizational, and activity cost drivers, as I am going to present in this post, provides a useful foundation for the study of managerial accounting.

 
The 3 Fundamental Cost Drivers

  • Structural Cost Driver – Fundamental choices about the size and scope of operations and Structural technologies employed in delivering products or services to customers. For example: Apple Computer’s decision to enter the online music distribution business.
  • Organizational Cost Drivers – Choices concerning the organization of activities and the involvement of persons inside and outside the organization in decision making. Authorizing lower-level employees to make decisions to solve problems is an example of an organizational cost driver.
  • Activity Cost Drivers – Specific units of work (activities) performed to serve customer needs that consume costly resources. Assembling a product is an example of an activity cost driver.

How can you use information about structural, organizational, and activity cost drivers to help you in implementing the organization’s strategy? It is important that an organization’s cost structure be aligned with its strategy. If your goal is to be a cost leader (such as Wal-Mart or Costco), you will want to make sure that the structural cost drivers, such as the type of buildings acquired and the displays used are consistent with this strategy.  Follow on…

 

 

Structural Cost Drivers

The types of activities and the costs of activities performed to satisfy customer needs are influenced by an organization’s size, its location, the scope of its operations, and the technologies used. Decisions affecting structural cost drivers are made infrequently, and once made, the organization is committed to a course of action that will be difficult to change.

For a chain of discount stores, as an example, possible structural cost drivers include:

  • Determining the size of stores – This affects the variety of merchandise that can be carried and operating costs.
  • Determining the type of construction – While a lean warehouse type of construction is less expensive, it is not an appropriate setting for selling high-fashion clothing.
  • Determining the location of stores – Locating in a shopping mall can cost more and subject the store to mall regulations but provides for more customer traffic and shared advertising.
  • Determining types of technology to employ in stores – A computerized system for maintaining all inventory and sales data requires a large initial investment and fixed annual operating costs while providing more current information. However, the computerized inventory and sales systems can be less expensive at high sales volumes than a less costly system relying more on clerks taking physical inventory.

 

Organizational Cost Drivers

Like structural cost drivers, organizational cost drivers influence costs by affecting the types of activities and the costs of activities performed to satisfy customer needs. Decisions that affect organizational cost drivers are made within the context of previous decisions affecting structural cost drivers.

In a manufacturing organization, previous decisions about plant, equipment, and location are taken as a given when decisions impacting organizational cost drivers are made.

Examples of organizational cost drivers at a manufacturing organization include making decisions regarding:

  • Working closely with a limited number of suppliers – This can help achieve proper materials in the proper quantities at the optimal time. Developing linkages with suppliers can also result in suppliers’ initiatives that improve the profitability of both organizations.
  • Providing employees with cost information and authorizing them to make decisions –  This helps improve decision speed and reduce costs while making employees more customer oriented. Production employees may, for example, offer product design suggestions that reduce manufacturing costs or reduce defects.
  • Reorganizing the existing equipment in the plant so that sequential operations are closer – This more efficient layout reduces the cost of moving inventory between workstations.
  • Designing components of a product so they can fit together only in the correct manner – This can reduce defects as well as assembly time and cost.
  • Manufacturing a low-volume product on low-speed, general-purpose equipment rather than highspeed, special-purpose equipment – Assuming the special-purpose equipment is more difficult and costly to set up for a new job, this decision can increase operating time and operating cost while reducing setup time and setup cost.

 

Activity Cost Drivers

Activity cost drivers are specific units of work (activities) performed to serve customer needs that consume costly resources. Several examples of activities in a restaurant were mentioned on the preface. The customer may be outside the organization, such as a client of an advertising firm, or inside the organization, such as an accounting office that receives maintenance services. Because the performance of activities consumes resources and resources cost money, the performance of activities drives costs.

The basic decisions concerning which available activities will be used to respond to customer requests precede the actual performance of activities. At the activity level, execution of previous plans and following prescribed activities are important. All of the examples of structural and organizational cost drivers involved making decisions.

In the following list of activity cost drivers for a manufacturing organization, note the absence of the decision-oriented words:

  • Placing a purchase order for raw materials
  • Inspecting incoming raw materials
  • Moving items being manufactured between workstations
  • Setting up a machine to work on a product
  • Spending machine time working on a product
  • Spending labor time working on a product
  • Hiring and training a new employee
  • Packing an order for shipment
  • Processing a sales order
  • Shipping a product

 

Identifying Activity Cost Drivers

Identifying the appropriate activity cost driver for a particular cost requires judgment and professional experience. In general, the cost driver should have a logical, causal relationship with costs. In many cases, the identity of the most appropriate activity cost driver, such as miles driven for the cost of automobile gasoline, is apparent.

In other situations, where different activity cost drivers might be used, scatter diagrams and statistical measures, such as the coefficient of determination, are helpful in selecting the activity cost driver that best explains past variations in cost. When scatter diagrams are used, the analyst can study the dispersion of observations around the cost-estimating line. In general, a small dispersion is preferred. If regression analysis is used, the analyst considers the coefficient of determination. In general, a higher coefficient of determination is preferred. The relationship between the activity cost driver and the cost must seem logical, and the activity data must be available.”

 

 
Changes In The Composition Of Manufacturing Costs [An Alternative Cost Driver Classifications]

The unit-level approach may have worked for Carnegie Steel Company, but it is inappropriate for multi-product organizations, such as General Electric. The unit-level approach becomes increasingly inaccurate for analyzing cost behavior when organizations experience the following types of changes:

  • From labor-based to automated manufacturing;
  • From a limited number of related products to multiple products, with variations in product volume and complexity (and related costs); and
  • From a set of similar customers to a diverse set of customers;

 

Here is an example illustrating changes in the percentage of manufacturing costs for three major cost categories:

  • Direct materials, the cost of primary raw materials converted into finished goods, have increased slightly as organizations purchase components they formerly fabricated. The word “direct” is used to indicate costs that are easily or directly traced to a finished product or service.
  • Direct labor, the wages earned by production employees for the time they spend converting raw materials into finished products, has decreased significantly as employees spend less time physically working on products and more time supporting automated production activities.
  • Manufacturing overhead, which includes all manufacturing costs other than direct materials and direct labor, has increased significantly due to automation, product diversity, and product complexity.

 

Changes in the composition of manufacturing costs have implications for the behavior of total costs and the responsiveness of costs to changes in cost drivers. Because direct materials and direct labor vary directly with the number of units, they are easy to measure. In the past, when manufacturing overhead was relatively small, it was possible to assume units of product or service was the primary cost driver. This is no longer true. Units of final product is no longer an adequate explanation of changes in manufacturing overhead for many organizations.

The past tendency to ignore overhead, while focusing on direct materials and direct labor, led one researcher to describe overhead-causing activities as the hidden factory. To better understand the hidden factory, several researchers have developed frameworks for categorizing cost-driving activities. The crucial feature of these frameworks is the inclusion of non-unit cost drivers. Depending on the characteristics of a particular organization, as well as management’s information needs, there are an almost unlimited number of cost driver classification schemes.

I consider two frequently applied cost driver classification schemes:

one based on a “manufacturing cost hierarchy“; and a second based on a “customer cost hierarchy“, which will be discussed next.

Read on…

 

The Manufacturing Cost Hierarchy

The most well-known framework, developed by “Cooper and Kaplan” for manufacturing situations, classifies activities into the following four categories:

  • A unit-level activity is performed for each unit of product produced. Oneida Silversmiths manufactures high-quality eating utensils. In the production of forks, the stamping of each fork into the prescribed shape is an example of a unit-level cost driver.
  • A batch-level activity is performed for each batch of product produced. At Oneida Silversmiths, a batch is a number of identical units (such as a fork of a specific design) produced at the same time. Batch-level activities include setting up the machines to stamp each fork in an identical manner, moving the entire batch between workstations (i.e., molding, stamping, and finishing), and inspecting the first unit in the batch to verify that the machines are set up correctly.
  • A product-level activity is performed to support the production of each different type of product. At Oneida Silversmiths, product-level activities for a specific pattern of fork include initially designing the fork, producing and maintaining the mold for the fork, and determining manufacturing operations for the fork.
  • A facility-level activity is performed to maintain general manufacturing capabilities. At Oneida Silversmiths, facility-level activities include plant management, building maintenance, property taxes, and electricity required to sustain the building.

 

Several additional examples of the costs driven by activities at each level are presented below:

1. Activity Level: Unit Level

Reason for Activity: Performed for each unit of product produced or sold

Examples of Activity Cost:

  • Cost of raw materials
  • Cost of inserting a component
  • Utilities cost of operating equipment
  • Some costs of packaging
  • Sales commissions

 

2. Activity Level: Batch Level

Reason for Activity: Performed for each batch of product produced or sold

Examples of Activity Cost:

  • 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)

3. Activity Level: Product Level

Reason for Activity: Performed to support each different product that can be produced

Examples of Activity Cost:

  • Cost of product development
  • Cost of product marketing such as advertising
  • Cost of specialized equipment
  • Cost of maintaining specialized equipment

 

4. Activity Level: Facility Level

Reason for Activity: Performed to maintain general manufacturing capabilities

Examples of Activity Cost:

  • Cost of maintaining general facilities such as buildings and grounds
  • Cost of nonspecialized equipment
  • Cost of maintaining nonspecialized equipment
  • Cost of real property taxes
  • Cost of general advertising
  • Cost of general administration such as the plant manager’s salary

 

When using a cost hierarchy for analyzing and estimating costs, total costs are broken down into the different cost levels in the hierarchy, and a separate cost driver is determined for each level of cost. For example, using the above hierarchy, the costs that are related to the number of units produced (such as direct materials or direct labor) may have direct labor hours or machines hours as the cost driver; whereas, batch costs may be driven by the number of setups of production machines or the number of times materials are move from one machine to another.

Other costs may be driven by the number of different products produced. Facility-level costs are generally regarded as fixed costs and do not vary unless capacity is increased or decreased.

 

Customer Cost Hierarchy

Classification schemes should be designed to fit the organization and meet user needs. A merchandising organization or the sales division of a manufacturing organization might use the following hierarchy.

  • Unit-level activity: performed for each unit sold.
  • Order-level activity: performed for each sales order.
  • Customer-level activity: performed to obtain or maintain each customer.
  • Facility-level activity: performed to maintain the general marketing function

 

This classification scheme assists in answering questions concerning the cost of individual orders or individual customers. If an organization sells to distinct market segments (for profit, not for profit, and government), the cost hierarchy can be modified as follows:

  • Unit-level activity
  • Order-level activity
  • Customer-level activity
  • Market-segment-level activity: performed to obtain or maintain operations in a segment.
  • Facility-level activity

 

The market-segment-level activities and their related costs differ with each market segment. This classification scheme assists in answering questions concerning the profitability of each segment.

Finally, an organization that completes unique projects for different market segments (such as buildings for IBM and the U.S. Department of Defense) can use the following hierarchy to determine the profitability of each segment:

  • Project-level activity: performed to support the completion of each project.
  • Market-segment-level activity
  • Facility-level activity

 

The possibilities are endless. The important point is that both the cost hierarchy and the costs included in the hierarchy be tailored to meet the specific circumstances of an organization and the interests of management.

In managing costs, management makes choices concerning structural and organizational cost drivers. These decisions affect the types of activities required to satisfy customer needs. Because different types of activities have different costs, management’s decisions concerning structural and organizational cost drivers ultimately affect activity costs and profitability. Good decision making at the level of structural and organizational cost drivers requires an understanding of the linkages among the types of cost drivers and costs of different activities, both in unit-level and multi-level in its hierarchies.