DIRECT COSTING: FEATURES, BENEFITS, AND EXAMPLES - DUDAS - 2025

The direct cost is a form of cost analysis using only variable costs to make decisions. It does not consider fixed costs, since it is assumed that they are associated with the moment in which they incurred. This method is a practical tool in which costing is used to decide on production and sales planning.

The rationale for treating fixed manufacturing costs as expenses is that the company would incur such costs, whether the plant was in production or idle. Therefore, these fixed costs are not specifically related to the manufacture of products.

The concept of direct costing is extremely useful for making short-term decisions, but it can lead to harmful results if used for long-term decision-making, as it does not include all the costs that must be applied in a longer-term decision.

Direct costing (materials and labor) is about quickly providing an overview so that you can perform a cost estimate or cost indicator.

characteristics

- Direct costing separates manufacturing overhead into fixed and variable. Variable costs - costs that increase with production volume - are treated as product costs; and fixed costs - costs that do not change with the volume of production - are considered expenses for the period.

- Fixed expenses are incurred, such as rent, depreciation, salary, etc., even if there is no production. Therefore, they are not considered product costs and are treated as period expenses. They are not transferable to the next period, as they are not included in the inventories.

- Does not show differences in the cost of production per unit if there are fluctuations in production.

- It can provide more accurate information for decision makers, as costs are better linked to production levels.

- Use the result of the contribution margin as follows:

Sales - variable expenses = contribution margin - fixed expenses = net profit, based on the number of units sold.

Advantages and disadvantages

Advantage

- It is of great help for the management of an organization when decisions must be made regarding cost control.

- It is very useful as an analysis tool. It does not contain the overhead allocation, which is not only irrelevant to many short-term decisions, but can be difficult to explain to someone who doesn't know accounting.

- Direct costing is very useful to control variable costs, because you can create an analysis of variance report that compares the actual variable cost with the estimated variable cost per unit. Fixed costs are not included in this analysis, since they are associated with the period in which they are incurred, as they are not direct costs.

- Allocation of overhead can take a large amount of time to complete, so it is common to avoid allocating overhead when external reporting is not required.

- Useful for outlining the change in earnings as sales volume changes. It is relatively simple to create a direct cost table that indicates at what production levels additional direct costs will be generated, so that management can estimate the profit for different levels of corporate activity.

Disadvantages

- It only assigns direct labor costs, resulting in not all expenses being transferred to the unit price of the item.

- It is prohibited to use it to present inventory cost reports according to generally accepted accounting principles and international financial reporting standards. These require a company to allocate indirect costs to its inventory asset for its external reporting.

If direct costing were used for external reporting, then fewer costs on the inventory asset would be included on the balance sheet, resulting in a higher cost burden on period expenses.

- Does not take into account indirect costs, as it is designed to make short-term decisions, where indirect costs are not expected to change.

However, all costs change in the long term, which means that a decision that may affect a company in the long term must take into account the changes in indirect costs in that long period of time.

Examples

First example

The ABC company is evaluating producing a new article. The direct costs calculated are $ 14 per unit, which is the estimated 70% of the unit sales price, which would be $ 20, consistent with similar products.

On the other hand, the total fixed costs are $ 45,000. With this information, the following feasibility calculation can be quickly performed. Sales of the item are projected at $ 20,000 per year.

The key to the above calculation is the direct cost of $ 14. The product would have to sell for $ 20, according to the general direct costing pricing policy, which is 70% of the selling price ($ 14/70% = $ 20).

The Marketing Department estimates that annual sales would be approximately 20,000 units. With sales of $ 400,000, net operating income would be $ 75,000, or 18.8% of sales.

Therefore, the project is worth exploring further. The percentage of net operating income far exceeds the break-even analysis.

Second example

Organization X only produces and sells product Y. The following financial information is known about product Y:

- Sale price per piece: $ 50.

- Direct material costs per product: $ 8.

- Direct cost of labor per product: $ 5.

- Variable indirect production costs per product: $ 3.

Detailed information regarding the months of March and April:

There was no initial stock in March. Fixed overhead costs are now budgeted at $ 4,000 per month and have been absorbed by production. A regular production is 400 pieces per month. Other additional costs:

- Fixed costs for sales: $.000 per month.

- Fixed administration costs: $ 2000 per month.

- Variable sales costs (commission): 5% of sales revenue.

First step

Calculation of total production costs per product based on direct costing.

Second step

Calculation of inventory and production value.

Third step

Calculation of the benefit with direct costing.

References

1. Investopedia (2018). Direct Cost. Taken from: investopedia.com.
2. Steven Bragg (2017). Direct costing. Accounting Tools. Taken from: accountingtools.com.
3. Vincent van Vliet (2018). Direct Costing. Taken from: toolshero.com.
4. Lumen Managerial Accounting (2018). 6.2 Variable Costing. Chapter 6: Variable and Absorption Costing. Taken from: courses.lumenlearning.com.
5. Wikipedia, the free encyclopedia (2017). Variable costing. Taken from: en.wikipedia.org.