Question

6) What are the three criteria a company should use to evaluate and choose a cost driver? Briefly explain each of the three criteria.

Answer 1

Cost drivers are the elements of a business that cause an overhead cost against the goods manufactured or services provided. Some cost drivers are necessary and unchangeable while others place a high than needed overhead cost against production. These unnecessary cost drivers ultimately drive down the margins and revenue produced.

According to experts, the criteria for determining and selecting cost drivers are particularly important. They are:

1. Degree of complexity, diversity and variation of the product (e.g., number of colors, sizes, ranges). There should be a sufficient number of cost drivers to reflect how the uniqueness (heterogeneity) of each cost object (e.g., product) consumes each activity cost. It is a one-to-one relation of the number of activity costs to their activity cost driver (See the typology of cost drivers and their allocation’s levels below).

2. Degree of accuracy of calculation. A rational number of cost drivers should be selected. If too few are selected, then some products will likely be over-costed and the others must be under-costed. This is because it is a zero sum cost error model. If too many are selected, then the extra administrative effort to collect the cost driver data may not offset the informational value from the incremental increase in accuracy of the product cost.

3. Degree of usefulness of information. The level of costing detail and accuracy depends on the type of decisions that the information will be used for.