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It’s a well-known fact that managing costs are essential for any business to maintain a healthy profit margin. But that’s not always so clear which specific costs are the most crucial to manage. In other words, what are the cost drivers of a business?
Many different factors can contribute to the overall cost of doing business. However, certain expenses are more significant than others, and companies need to identify and focus on these key cost drivers.
By doing so, they can make more informed decisions about where to allocate their resources to achieve the best results.
What are cost drivers
In simple words, cost drivers are the reason for a cost, and how that cost affects the total amount spent.
This means that cost drivers don’t just refer to the amount of money spent on a particular item. Instead, they encompass all of the factors that contribute to the overall cost.
For example, the cost of rent might include not only the monthly payment but also the cost of utilities, insurance, and other associated expenses.
In other words, the cost driver of rent would be the total amount of money spent on rent, utilities, insurance, and so on. Cost drivers are just a term for the various factors that contribute to the total cost.
Understanding how cost drivers work
To understand how cost drivers work, it’s helpful to think about them in terms of cause and effect.
Let’s take the electricity bill as an example. The amount of electricity used is the cause, and the resulting electricity bill is the effect.
In this case, the cost driver is the amount of electricity used. This is because the more electricity that’s used, the higher the bill will be.
Similarly, the cost driver of rent might be the number of square feet in the rental space. The more square footage, the higher the rent will be.
These cause-and-effect relationships are what make cost drivers so important. By understanding which factors contribute to the overall cost, companies/individuals can make more informed decisions about where to allocate their resources.
Different types of cost drivers
There are mainly two types of cost drivers: Direct and indirect.
Direct cost drivers
Direct cost drivers are those that have a direct impact on the cost of a product or service.
For example, the direct cost of manufacturing a widget might include the cost of materials, labor, and overhead.
Indirect cost drivers
Indirect cost drivers are those that don’t have a direct impact on the cost of a product or service, but they still affect the overall cost.
For example, the indirect cost of manufacturing a widget might include the cost of shipping, marketing, and research and development.
It’s important to note that both direct and indirect cost drivers can have a significant impact on the bottom line. This is why companies need to identify and focus on the key cost drivers of their business.
Cost drivers are a common tool used in business to help identify and manage the costs associated with a product or service. By understanding which factors contribute to the overall cost, companies/individuals can make more informed decisions about where to allocate their resources.
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