What is the best way to choose an appropriate cost driver when applying factory overhead

1.0 IntroductionThis report has been prepared for Maureen Pistana, the Chief Financial Officer of Greenwoodindustries. In this report, the first part will focus on an analysis in order to discuss planningissues. In other words, an improvement concerning the scheduling of temporary workers toincrease efficiency of customer orders should be taken.Secondly, in the other part of the report, there will be an overview on the overhead costs for agiven time period. A review on the resources spent on the manufacturing of products will beassessed.Finally, to elaborate on changes in costing more precisely to assess whether to phase out aproduct model and focus on another model in order to increase profit and sales.2.0 Regression AnalysisRegression analysis is defined as a statistical method that measures the average amount ofchange with regards to the relationship between a dependant variable and independentvariables also known as the cost driver. A cost driver is an event that causes costs to beincurred.In order to determine the number of temporary workers required for July using bothregression equations, the linear cost function (Y= a + bX) should be applied. In this caseanalysis, the cost driver is the number of orders.

SME 2001 MANAGERIAL ACCOUNTING (MAC) – QUIZ #2Question 1: (1 point)Predetermined overhead rates are computed by which of the following series of steps?a)1- Estimate the factory overhead costs for an appropriate operating period, 2 - Select the most appropriate cost driver(s) for applying thefactory overhead costs, 3 – Estimate the total amount or activity level of the chosen cost driver(s) for the operating period, 4 -Divide theestimated activity level of the chosen cost driver(s) by the estimated factory overhead costs to obtain the predetermined overhead rate.b)1- Estimate the factory overhead costs for an appropriate operating period, 2 - Select the largest cost driver for applying the factoryoverhead costs, 3 – Estimate the total amount or activity level of the largest cost driver(s) for the operating period, 4 -Divide theestimated factory overhead costs by the estimated activity level of the largest cost driver(s) to obtain the predetermined overhead rate.c)1- Estimate the factory overhead costs for an appropriate operating period, 2 - Select the most appropriate cost driver(s) forapplying the factory overhead costs, 3 – Estimate the total amount or activity level of the chosen cost driver(s) for the operatingperiod, 4 -Divide the estimated factory overhead costs by the estimated activity level of the chosen cost driver(s) to obtain thepredetermined overhead rate.d)1- Estimate the factory overhead costs for an appropriate operating period, 2 - Select the largest cost driver for applying the factoryoverhead costs, 3 – Estimate the total amount or activity level of the largest cost driver for the operating period, 4 -Divide the estimatedactivity level of the largest cost driver(s) by the estimated factory overhead costs to obtain the predetermined overhead rate.

Question 2: (1 point)Why are predetermined factory overhead rates used to apply factory overhead to units of production instead of actual overhead costs?

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What is a Cost Driver?

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. A large number of cost drivers may be used within an activity-based costing system. 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.

Examples of Cost Drivers

Examples of cost drivers are direct labor hours worked, the number of customer contacts made, the number of engineering change orders issued, the number of machine hours used, and the number of product returns from customers.

What Is an Activity Cost Driver?

An activity cost driver is an accounting term. A cost driver affects the cost of specific business activities. In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.

How Activity Cost Drivers Work

A cost driver directly influences a business activity. There may be multiple cost drivers associated with an activity. For example, direct labor hours are a driver of most activities in product manufacturing. If the cost of labor is high, this will increase the cost of producing all company products or services. If the cost of warehousing is high, this will also increase the expenses incurred for product manufacturing or providing services.

An activity cost driver, also known as a causal factor, causes the cost of an activity to increase or decrease. An example is a change in the cost of warehousing or a change in the level of production.

More technical cost drivers are machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.

Key Takeaways

• Activity-based costing (ABC) is an accounting method that allocates both direct and indirect costs to business activities.
• A cost driver simplifies the allocation of manufacturing overheads, such as the costs of factory space and electricity.
• Management selects cost drivers based on the associated variables of the expense incurred.

Cost Allocation

When a factory machine requires periodic maintenance, the cost of the maintenance is allocated to the products produced by the machine. For example, the cost driver selected is machinery hours. After every 1,000 machine-hours, there is a maintenance expense of $500. Therefore, every machine hour results in a 50 cent (500 / 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine-hours.

Distribution of Overhead Costs

A cost driver simplifies the allocation of manufacturing overhead. The correct allocation of manufacturing overhead is important to determine the true cost of a product. Internal management uses the cost of a product to determine the prices of the products they produce. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity.

Fast Fact

Activity-based costing (ABC) is a more accurate way of allocating both direct and indirect costs. ABC calculates the true cost of each product by identifying the amount of resources consumed by a business activity, such as electricity or man hours.

Special Considerations: The Subjectivity of Cost Drivers

Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.

How do I choose a cost driver?

What is the cost driver for overhead?

Why is it important to identify the most appropriate cost drivers for a particular product?

What driver or drivers would you use to allocate overhead costs to the enterprise?