Improving performance with cost drivers.

IMPROVING PERFORMANCE WITH COST DRIVERS

Due to changes in manufacturing, the traditional overhead allocation method can lead to inaccurate products costs. Frank Collins, CPA, professor of accounting, and Michael L. Werner, CPA, lecturer in accounting at the University of Miami, Coral Gables, Florida, illustrate how the new cost-driver approach can improve cost management. Traditionally, most companies allocated costs to production using application bases such as direct labor. However, as businesses become more capital intensive and production methods change, this procedure can lead to inaccurate determinations of product costs. The new cost-driver approach can remedy this situation.

USING COST DRIVERS

The cost-driver approach allocates a cost to production, based on the actions or factors that cause it. For example, the cleanup costs of a printing press might be allocated based on the number of colors used. As illustrated in the sidebar on TRADITIONAL vs. COST-DRIVER APPROACHES this results in more accurate costing.

The exhibit on Basic work phases and cost drivers shows typical cost drivers for the various stages of work (planning, getting ready to work, working, finishing and inspecting work). Examining the second stage--getting ready to work--we find activities that contribute costs to this stage include ordering raw materials and setting up machines. After accumulating applicable costs in pools, cost drivers are used to allocate these cost pools to production. Potential cost drivers for this second stage include the number of production runs or machine set-ups. If it is determined the number of production runs is the most appropriate cost driver, this pool is allocated to production in proportion to the number of production runs necessary to make the product.

TRADITIONAL APPROACH

How does this approach differ from the traditional one? Traditionally, costs are pooled and allocated to production as a function of direct labor hours or machine hours. These bases are used because it is assumed that, over the long run, factory costs are likely to be highly correlated with one of these measures. But because of changes in manufacturing this is often no longer true.

A rate per hour is determined and used to allocate each cost pool to the product. See the sidebar below for a comparison of the traditional and cost-driver approaches to allocating cleanup costs in a printing company.