A Factor That Causes Overhead Costs Is Called a Cost Driver
Explore how cost drivers influence overhead costs, the different types, and why certain expenses don't impact overhead as drivers.
Understanding what influences overhead costs is crucial for businesses aiming to manage expenses efficiently. Cost drivers, elements that cause a change in the cost of an activity, play a pivotal role in allocating and controlling overhead. They directly impact financial planning and decision-making processes.
The Role of Cost Drivers in Overhead
Cost drivers help businesses identify the factors influencing overhead costs and allocate resources effectively. In manufacturing, machine hours or labor hours often determine how overhead is assigned to products, providing a clearer picture of production costs and aiding in pricing and budgeting.
In service industries, cost drivers might include the number of transactions or the complexity of services provided. For example, a consulting firm might use client meetings or project hours to determine the overhead associated with each client or project. This precision ensures pricing strategies reflect actual costs, maintaining profitability and competitiveness.
Analyzing cost drivers also helps businesses identify inefficiencies and implement cost control measures. If a particular process significantly drives overhead, management might consider automation or process improvements to reduce its impact.
Types of Overhead Drivers
Understanding different types of overhead drivers allows businesses to allocate costs accurately and improve financial management. These drivers can be categorized into volume-related, transaction-related, and complexity-related, each influencing overhead differently.
Volume-Related
Volume-related cost drivers are tied to activity levels or output quantities, such as machine hours, labor hours, or units produced. For instance, a factory producing 10,000 units with $50,000 in overhead might use machine hours to allocate costs. If each unit requires 0.5 machine hours, the overhead rate is $10 per machine hour. This approach helps businesses set competitive prices and manage production efficiency.
Transaction-Related
Transaction-related cost drivers are based on the number of transactions or activities performed, particularly in service-focused industries. In retail, the number of sales transactions might determine overhead costs. For example, a store with $30,000 in overhead and 3,000 sales transactions would allocate $10 per transaction. This method clarifies the cost implications of each transaction, enabling businesses to streamline operations.
Complexity-Related
Complexity-related cost drivers stem from the intricacy of operations or products, often resulting in higher overhead costs. Industries with customized or specialized services frequently encounter these drivers. For example, a law firm might allocate more overhead to complex cases requiring additional resources. If a firm incurs $100,000 in overhead for 50 cases, with 10 complex cases, a larger share of costs would be assigned to those cases. Recognizing complexity-related drivers allows businesses to allocate resources effectively and optimize pricing.
Why Some Expenses Don’t Affect Overhead as Drivers
Not all expenses function as overhead drivers. Fixed costs, such as rent or salaried employee wages, remain consistent regardless of production levels or service activities. These costs do not fluctuate with operational volume, making them unsuitable as drivers.
Regulatory or compliance-related expenses also typically fall outside the scope of overhead drivers. Costs related to compliance with laws like the Sarbanes-Oxley Act or Dodd-Frank Act, such as audit fees or compliance software, are necessary for legal adherence but don’t directly correlate with production or service metrics. These are often categorized as administrative or general expenses to ensure transparency in financial reporting.
Strategic investments like research and development (R&D) are another category of expenses that do not align with traditional overhead drivers. R&D costs are typically treated as investments in future growth rather than current operations. Under the Internal Revenue Code Section 174, these expenses are often deducted in the year incurred, reflecting their long-term strategic value rather than immediate overhead impact. Companies separate R&D from operational overhead to better assess its role in fostering innovation and achieving long-term objectives.