Cost Drivers and the Decision-Making Process

Managers should always use a long time horizon to identify cost drivers. Why? Because costs may be fixed in the short run (during which time they have no cost driver), but they are usually variable and have a cost driver in the long run. Focusing on the short run may inadvertently cause a manager to believe that a cost has no cost driver.

Consider Elegant Rugs, which uses state-of-the-art automated weaving machines to produce carpets for homes and offices. Managers want to introduce new styles of carpets and manage costs. They follow the five-step decision-making process outlined in Chapter 1 to estimate costs and what styles of carpets they should introduce.

  1. IDENTIFY THE PROBLEM AND UNCERTAINTIES. Elegant Rugs’ managers are confident about the direct materials and direct manufacturing labor costs of the new styles of carpets. They are less certain about the impact of different styles on indirect manufacturing labor costs such as supervision, maintenance, and quality control costs. Managers want to understand the drivers of indirect manufacturing labor costs and use this knowledge to determine the styles of carpets to produce as well as how best to manage costs.
  2. OBTAIN INFORMATION. Managers gather information about potential cost drivers of indirect manufacturing labor costs such as machine-hours or direct manufacturing labor-hours. They also begin to explore different techniques (discussed in the next section) for estimating the cost function. Their goal is to identify the best possible single cost driver.
  3. MAKE PREDICTIONS ABOUT THE FUTURE. Managers use past data to estimate the relationship between the cost drivers and costs and use this relationship to predict future costs.
  4. MAKE DECISIONS BY CHOOSING AMONG ALTERNATIVES. As we will see (ni section in section Evaluating and Choosing Cost Drivers), managers chose machine-hours as the cost driver. Using regression analysis, they estimated indirect manufacturing labor costs per machine-hour both to manage costs and to choose alternative styles of carpets to maximize profits.
  5. IMPLEMENT THE DECISION, EVALUATE PERFORMANCE, AND LEARN. A year later managers evaluated the results of their decision. Comparing predicted to actual costs helped them determine how accurate the estimates were, set targets for continuous improvement, and seek ways to improve Elegant Rugs’ efficiency and effectiveness.