Direct costing

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Direct costing
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Direct costing (often also referred to as variable costing) is a cost accounting method that tries to increase the rationality of managerial decision making. Direct costing only takes variable cost components of a product into account, i.e. the costs that vary depending on a company’s production volume. Therefore, it leaves the fixed costs out of consideration as they are not depending on the production level of the company. Hence, direct costing is the counterpart to the full cost method, which is also known as absorption costing. It is a common debate about which of both costing methods is more rational and more reliable for the evaluation of inventories as well as decision making. There are three main issues/questions that lead this debate:

  • Profitable price setting based on unit cost: what price needs to be achieved to be profitable?
  • Product program decisions: should a production process be activated or de-activated?
  • Product mix: which product mix is the most profitable - especially given scarce input factors (A.M. Moisello, P. Mella 2019, pp. 203-213)?

The term contribution margin plays a major part in direct costing and represents the key indicator for the above-mentioned debate (P. Schuster, M. Heinemann, P. Cleary 2021, p. 23).

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The primary role of direct costing is the segregation of variable and fixed costs, the evaluation of inventories is just secondarily (B.G. Waller 1971, p. 9).

Reasons to use Direct Costing

The concept of direct costing was developed to overcome the disadvantages of the full costing method. The calculations within the full costing method is insufficient to support operating managerial decision making as the fixed costs (or indirect costs) can only be influenced in the long term, therefore they are not relevant for short term decision making. In comparison to that, the direct costing method is appropriate to provide an adequate base for rational decision making in the short run (A.M. Moisello, P. Mella 2019, pp. 203-204). For short term decisions, it is sufficient to gain a positive contribution margin in order to behave rationally. Hence, it is only necessary to cover the variable cost (or marginal cost) in the short run because the fixed costs are irrelevant. Thus, the short term lowest price limit can be determined by using direct costing (P. Schuster, M. Heinemann, P. Cleary 2021, pp. 63-64).

The following example tries to emphasize the possible problems that could occur from a management point of view in price setting and cost-volume-profit (CVP) relationship by using the full cost method and the underlying assumption of fixed cost proportionality:

Example of possible errors
Product A Product B Product C
Variable cost 8,000 € 6,000 € 9,600 €
Fixed cost 3,500 € 3,500 € 3,500 €
Total cost 11,500 € 9,500 € 13,100 €
Production units 1,000 pc. 750 pc. 1,200 pc.
Cost per unit 11.50 € 12.67 € 10.92 €
Profit margin (25%) 2.30 € 2.53 € 2.18 €
Price per unit 13.80 € 15.20 € 13.10 €

The table above shows that the full cost approach for determining the price per unit can lead to major errors. First, as the fixed costs are allocated based on the number of units produced, the cost per unit is not comparable and not reliable as it highly depends on the production output. Furthermore, the lower the number of units produced, the higher the estimated price per unit will be by using this method – which could lead to major problems as higher prices usually imply less sales, which in the end could result in an even higher price per unit in the future. If the same situation is approached with the direct costing method, no inconsistencies in the pricing should be made as the variable cost per unit would remain constant over the three periods:

Example of possible errors
Product A Product B Product C
Variable cost 8,000 € 6,000 € 9,600 €
÷ Production units 1,000 pc. 750 pc. 1,200 pc.
Variable cost per unit 8.00 € 8.00 € 8.00 €

Thus, direct costing provides the management of a company with a more useful set of information that can be used for profit planning as well as for product-profitability analysis – as it no longer suffers from variations due to different levels of production (B.G. Waller 1971, pp. 9-37).

CVP Analysis with direct costing

One of the most useful adaptions of direct costing is the CVP Analysis. By the use of direct costing, a company can gain a range of useful information regarding its profitability and costing. This can be shown by a simple example:

Example of possible errors
Product A Product B Product C
Price per unit 250 € 200 € 100 €
= Contribution margin 30 € 10 € 20 €
Contribution margin (%) 12 % 5 % 20 %

By looking at the absolute contribution margin, one may think that Product A is the most profitable for the company, but Product C is the most profitable as it has the highest relative contribution margin compared to the underlying price (M. Franklin, Mitchell, P. Graybeal, D. Cooper 2019, pp. 128-131).

This way of contribution analysis can help the management to make production program decisions. Such a program decision needs to be made in case of a bottleneck situation. In such a situation the management has to decide which product should be prioritized. Based on the example above such a management decision will be illustrated: Assumption: All three products are produced with the same machine, but the machine just has a capacity of 1.000 h.

Example of possible errors
Product A Product B Product C
Contribution margin 30 € 10 € 20 €
Potential sales 75 200 100
Production time per unit 10h 5h 5h
Contribution margin per bottleneck unit 3 € 2 € 4 €
Priority 2 3 1

Again, one could have thought that it is the most rational decision to prioritize the production of the product with the highest absolute contribution margin (in this case: Product A). But by looking at the contribution margin per bottleneck unit, the company should prioritize the production of Product C as it generates the highest contribution margin. Therefore, the company should allocate its scarce resource to the following production program to maximize its contribution margin:

  • Product C: 100 units
  • Product A: 50 units
⇒ Contribution margin: 100 x 20 € + 50 x 30 € = 3.500 € (M. Franklin, Mitchell, P. Graybeal, D. Cooper 2019, pp. 536-540).

Implications for financial position and financial performance

In financial accounting, the application of direct costing and full costing can result in different outcomes in the financial position and financial performance. The respective choice can influence the financial position through the evaluation of inventories on the one hand and the profit situation through the cost of goods sold (COGS) on the other hand. Thus, it is a very important decision to be made.

The difference in the financial position simply results from the lower cost base of direct costing, as only variable cost components (such as direct labor, direct materials, and the variable portion of manufacturing overheads) are considered in the valuation of inventories, whereas the full cost method also considers fixed components. Hence, the value under direct costing is always lower than under full costing (C.A. Bunea-Bontas 2013, pp. 123-128).

The financial performance deviates due to the different treatment of production costs in the income statement. Under the direct costing method, a distinction between variable and fixed production costs will be made. The production cost per unit only includes variable components, while all fixed production overheads are deducted at once and not allocated per unit. While the full cost method does not apply this distinction and just allocates the fixed production overheads per unit, which results in a higher cost per unit compared to direct costing. Therefore, the income statement is structured differently for both methods as a different calculation base is used.

Example: Company X produced 10.000 units and sold 8.000 units for 40 € with the following cost structure:

  • Direct material: 8 €
  • Direct labor: 6 €
  • Variable production overheads: 2 €
  • Variable selling and administrative expenses: 5 €
  • Fixed production overheads: 60,000 €
  • Fixed selling and administrative expenses: 30,000 €

Calculation of production cost per unit:

Direct costing
Direct material 8 €
+ Direct labor 6 €
+ Variable production overheads 2 €
Production cost per unit 16 €
Full costing
Direct material 8 €
+ Direct labor 6 €
+ Variable production overheads 2 €
+ Fixed production overheads 6 €
Production cost per unit 22 €

The given example shows that the production cost per unit under full costing method is 6 € than under direct costing, which is directly referable to the fixed production overheads (60.000 € / 10.000 units).

This calculation difference will also affect the income statement and lead to a deviation in net operating income, which reflects the difference in financial performance.

Income statement:

Direct costing
Sales (8,000 units x 40 €) 320,000 €
- COGS (8,000 units x 16 €) 128,000 €
- variable selling and administrative expenses (10,000 units x 5 €) 50,000 €
= Contribution margin 142,000 €
- Fixed expenses:
- Fixed production overheads 60,000 €
- Fixed selling and administrative expenses 30,000 €
= Net operating income 52,000 €
Full costing
Sales (8,000 units x 40 €) 320,000 €
- COGS (8,000 units x 22 €) 176,000 €
= Gross margin 144,000 €
- Selling and administrative expenses:
- Variable selling and administrative expenses (10.000 units x 5 €) 50,000 €
- Fixed selling and administrative expenses 30,000 €
= Net operating income 64,000 €

The net operating income under the direct costing method considers all fixed expenses that occurred within the production period as all fixed expenses are deducted at once, only the variable production components are still part of the balance sheet as part of inventories. In comparison to that, the full costing method only considers the fixed costs of the goods sold, so a higher amount is still within the balance sheet, e.g., in the valuation of inventories. Hence, the direct costing method leads to a lower net operating income if a company sells fewer goods than it produces.

This shows a major advantage of direct costing. It solves one of the main problems of the full costing method, the time lag between the incurrence of a cost within the current period and its recognition as an expense in the income statement. Another important advantage of direct costing is the ability to calculate the contribution margin, which allows deeper insights regarding the profitability of individual products. This information is also useful for CVP analysis (C.A. Bunea-Bontas 2012, pp. 35-39).

Limits of direct costing

After broadly discussing the concept and advantages of direct costing, it also has its limitations and disadvantages:

  • Financial reporting: the direct costing method is often not accepted within GAAP, as it usually requires expenses to be recognised in the period as the related revenue occurs,
  • Tax reporting: the tax law in many countries (for example the United States) requires the use of absorption costing (M. Franklin, Mitchell, P. Graybeal, D. Cooper 2019, pp. 317-318),
  • Insufficient for long term pricing as fixed production costs are relevant in the long run (P. Schuster, M. Heinemann, P. Cleary 2021, pp. 62-80).

Examples of Direct costing

  • Direct costing is often used in product pricing. It helps companies determine the cost for each unit of a product by taking into account only the variable costs associated with the product, such as the cost of the raw materials and labor needed to produce the item. By taking into account only the variable costs, companies can more accurately estimate the cost of each unit of their product and adjust their prices accordingly.
  • Another example of Direct costing is in budgeting. Companies use direct costing to determine the costs associated with a particular project or operation. By taking into account only the variable costs, such as the cost of labor, materials and other related expenses, companies can more accurately determine the cost of a given operation and adjust their budget accordingly.
  • Direct costing is also useful for decision making. Companies use this method to analyze the costs and benefits of various decisions. By taking into account only the variable costs, companies can better assess their options and make more informed decisions.

Advantages of Direct costing

Direct costing has a number of advantages when it comes to decision making, rationalization and evaluation of inventories. These advantages include:

  • Increased transparency: Direct costing allows for a more transparent view of production costs and expenses, making it easier to identify areas where cost savings can be made.
  • Quicker decision making: Direct costing is a much simpler approach to cost accounting and requires fewer calculations, allowing for quicker decision making.
  • Improved cost accuracy: Direct costing takes into account only the variable costs associated with production, resulting in improved cost accuracy.
  • Easier to track expenses: As direct costing only takes variable costs into account, it is easier to track expenses as they are directly linked to production levels.
  • Improved inventory management: As direct costing only takes variable costs into account, it makes inventory management easier and more accurate.

Limitations of Direct costing

One of the main limitations of direct costing is that it neglects all fixed costs of a company. These fixed costs are part of the cost of a production but they are not considered in direct costing. This can lead to incorrect evaluations and decisions. The following are some of the limitations of direct costing:

  • Direct costing does not take into account the fixed costs of production, such as depreciation or rental costs. These fixed costs are not linked to the production volume and, consequently, do not vary with it. This means that the cost of production may be underestimated and the profits overstated.
  • Direct costing does not consider the long-term profitability of a product; it only takes into account the short-term costs. This can lead to incorrect decisions being made as the long-term effects of a decision may not be taken into account.
  • Direct costing does not consider indirect costs, such as the costs of research and development or marketing. These costs may be essential in determining the profitability of a product but are not taken into account in direct costing.
  • Direct costing does not take into account any potential economies of scale that may be achieved in the future. This means that the full potential of a product may not be taken into account when evaluating it.
  • Direct costing does not consider the opportunity cost of producing a product, which may be significant in certain circumstances. This means that the true cost of production may not be accurately represented.

Other approaches related to Direct costing

  • Activity-Based Costing (ABC): ABC is a more detailed costing approach, which considers both variable and fixed costs and assigns them to certain activities that are related to the production process.
  • Target Costing: This approach helps companies to set a target cost for a product in order to meet the required profit margins and is based on the expected market price.
  • Throughput Accounting (TA): TA is a costing approach that is focused on minimising the time it takes to produce a product and aims to reduce the cost for the production of each unit.
  • Life Cycle Costing (LCC): LCC is a costing approach that considers the entire life cycle of a product, from the design and production to the usage and disposal.

In conclusion, besides direct costing, there are other cost accounting approaches that can be used for decision-making such as Activity-based Costing, Target Costing, Throughput Accounting and Life Cycle Costing. Each of these methods has its own advantages and disadvantages and can be used to assess the production costs and profit margins of a company in a more accurate and detailed way.

References

Author: Robin Jungert