A cost driver triggers a change in the cost of an activity. The concept is most commonly used to assign overhead costs to the number of produced units. It can also be used in activity-based costing analysis to determine the causes of overhead, which can be used to minimize overhead costs. Examples of cost drivers are as follows:

• Direct labor hours worked

• Number of customer contacts

• Number of engineering change orders issued

• Number of machine hours used

• Number of product returns from customers

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Bauer Manufacturing uses department cost driver rates to allocate manufacturing overhead costs to products. Manufacturing overhead costs are allocated on the basis of machine-hours in the Machining Department and on the basis direct labor-hours in the Assembly Department.

If a business is only concerned with following the minimum accounting requirements to allocate overhead to produced goods, then just a single cost driver should be used.

Related Courses

Activity-Based Costing
Activity-Based Management
Cost Accounting Fundamentals

Volume-Based Overhead Rate: Definition, Features and Limitations!

Concept:

Traditional product costing system is also referred to as functional-based cost accounting system or volume-based costing system. Traditional (or conventional) product costing system determines product cost by way of allocating, in the first stage, direct costs to the products and then subsequently adding a proportion of overheads deemed to be related to the units produced.

In this costing system, overheads are charged to products on a production volume related basis such as direct labour hours, direct labour cost, and machine hours. This costing system is based on the assumption that all overheads are related basically to production volume.

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Traditional product costing was developed when direct material costs and direct labour costs accounted for the bulk of product costs incurred inside a firm or factory. Factory overheads tend to serve all production and hence cannot be directly identified with or traced to, products or services.

In the past, labor activities were a major manufacturing activity. The other major manufacturing cost item, direct materials costs, consists of payments to vendors rather than costs incurred inside the factory. With labor costs being a primary manufacturing cost and labor activities being the major activity in the manufacture of a product, volume-based costing systems focus on measuring and con­trolling direct labor costs.

Factory overheads are a small fraction of the labor cost and are deemed as resources expended to support labor activities. Tying to direct labor costs, a traditional overhead costing system becomes a volume-based costing system. As volumes (units) change, direct labor costs, as do overhead costs, vary in proportion to changes in units of production.

Functional-based (volume-based) costing system has the following features:

(i) It assumes simple labour based production norm and low level of mechanisation.

(ii) Direct costs i.e. direct material and direct labour, have larger proportion in the total costs of production.

(iii) Overhead costs are in small proportion because support or servicing functions such as planning, purchasing, accounting, finance, administration etc. are less.

(iv) Standardised products are generally assumed to be produced.

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(v) This costing system is assumed not to be affected much by technology changes and production methods and products are subject to slow rate of changes.

Volume-Based Overhead Rate:

The factory overhead rate in a volume-based costing system is either a single overhead rate for the entire operation (plant-wide rate) or a set of overhead rates with various rates for different depart­ments or divisions (departmental rates). These overhead rates use an output-volume-based activity or activities to assign (or to spread) factory overhead costs to products or services. An output-volume- based costing system spreads costs evenly so that each cost object (product or service) receives the same amount.

Limitations of Volume-Based Costing System:

Volume-based costing system have served well since the inception of cost accounting. How­ever, remarkable changes have taken place in production methods, organisational structure, cost behaviour and magnitudes. Production is now automated and computerised. Overheads now-a- days constitute a very high proportion of total costs as compared to direct labour. Support func­tions and their costs have shown increasing trends continually. Thus, at present, overheads are less affected by production volume (as in conventional costing), but more by range and complexity of products manufactured.

The following are the limitations of volume-based costing system:

1. Different products utilize different amount of resources, which is not recognized in traditional costing system.

2. Overheads now constitute the Largent share of cost, often greater than 50% and is typically applied to products as percentage of the smallest cost (direct labour) leading to serious distortion of product cost.

3. By relying on volume-related measures to determine product costs, traditional costing system do a poor job in reflecting supporting costs for manufacturing and distribution of products or services. More and more factory overheads, such as setup cost, materials handling cost, and product design and research and development costs, are unrelated to the number of units produced.

4. Traditional costing system tends to over-cost standard, high volume products and under-cost low volume products, leading to incorrect pricing and product mix decisions.

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5. It creates a bias toward direct labor reduction as a cost reduction technique rather than overall productivity improvement.

6. It provides no information useful in either identifying productivity improvement opportunities or determining if productivity improvement efforts have yielded significant results. Indeed, often traditional costing system indicates higher cost in the presence of known productivity improvement or vice versa.

Thus, companies that apply plant-wide and departmental overhead rates to assign overhead costs to products often do not produce reliable cost data. Conventional product costing system follows a cost smoothening or peanut-butter costing which describes a costing approach that uses broad averages for distributing the cost of resources uniformly to cost objects (such as product or services) when the individual products or services, in fact, use those resources in a non-uniform way.

For some companies, product cost distortions can be damaging, particularly for those characterized by intense or increasing competitive pressures, continuous improvement, total quality management, total customer satisfac­tion and sophisticated technology. As firms operating in this competitive environment adopt new strategies to achieve competitive excellence, their cost accounting systems often must change to keep pace. Cost accounting systems that worked reasonably well in the past may no longer be acceptable.

Blocher, Chen, Cokins and Lin Observe:

“A volume-based overhead costing system, whether plant-wide or departmental, often leads to inaccurate product costs, especially for firms with complex manufacturing operations—firms with varieties of products or heterogeneous production processes. As firms increase in variety of product, volume, size, or complexity, resources used and costs spent on supporting activities, increase. Dis­tortions of volume-based overhead cost systems increase as product diversity increases because the cost system (1) is designed to cost products in the aggregate, not to related to unique manufacturing characteristics in different operations; (2) uses a common plant-wide or departmental cost driver and ignores differences in activities for different products or production runs within the plant or depart­ment; (3) employs a common activity volume for all operations such as direct labor-hours or dollars as the base to distribute overhead costs to all products while the selected activity is a small portion of the overall production activities; and (4) deemphasizes long-term product analysis. Users of traditional volume-based cost data who are aware of likely distortions in cost data from a volume-based costing system, often attempt to make intuitive, and likely, imprecise adjustments to the volume-based cost information without understanding their complete effect and, thereby, distort the cost information further. Inaccurate cost information can lead to undesirable strategic results, such as wrong product-line decisions, unrealistic pricing, and ineffective resource allocations.”

Situations under which Traditional Costing System can be Used:

A volume-based costing system may provide reasonably accurate costs when a business firm possesses the following characteristics:

1. Few and very similar product and service lines.

2. Low overhead expenses.

3. Similar distribution channels, customer demands and customers.

4. Similar conversion process for all products or services.

5. High margins of products and services.