Direct costing
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 (A.M. Moisello, P. Mella 2019, pp. 203-213):
- 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)
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:
| 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:
| 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, p. 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:
| 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.
| 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 material | 8 € |
| + Direct labor | 6 € |
| + Variable production overheads | 2 € |
| Production cost per unit | 16 € |
| 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:
| 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 € |
| 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).
References
- Bunea-Bontas, C. A. (2012). Theoretical And Practical Considerations Regarding The Cost Calculation Using Direct Costing, Management Strategies Journal, Constantin Brancoveanu University, vol. 18(4), pages 35-39.
- Bunea-Bontas, C. A. (2013). The cost of production under direct costing and absorption costing – a comparative approach. Annals - Economy Series 2, S. 123–129.
- Franklin, M., Graybeal, P.; Cooper, D. (2019). Principles of accounting. Houston, Texas: OpenStax, Rice University.
- Moisello, A. M., Mella, P. (2019). Matching Revenues and Costs: The Counter-Intuitive Rationality of Direct Costing. In: IJBM 15 (1), S. 202.
- Schuster, P., Heinemann, M., Cleary, P. (2021). Management accounting. Cham, Switzerland: Springer (Springer texts in business and economics).
- Waller, B. G. (1971). Direct costing versus absorption costing. George Washington University.
Author: Robin Jungert
