Direct Costing

Direct Costs
Direct Costs are direct materials, direct labour and other costs directly assignable to a product.

Direct (Marginal) Costing

Direct costing is a procedure by which only prime costs plus variable FOH are assigned to the
product or inventory; all fixed costs are considered period costs.

Period Costs VS Product Costs

Period Costs
Period costs are charged against the income of the current period. In direct costing, fixed FOH as
well as selling and administrative expenses are treated as period costs.

Product Costs

Costs that apply to the production of goods are called period costs. Variable manufacturing costs
(Direct Materials, Direct Labour and Variable FOH) are typical product costs in Direct Costing
and are charged against the income when the units to which they relate are sold.

Marginal Costing VS Absorption Costing

Marginal (Direct Costing)
Marginal costing is a costing procedure in which only variable manufacturing costs are charged
to the products and inventory, while fixed manufacturing costs become period costs.

Absorption Costing
Absorption costing is a costing procedure which assigns Direct Materials, Direct Labour and a
share of both fixed and variable FOH to units of production.

Marginal(Differential) Cost
Marginal cost is the additional cost of producing an additional unit.

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 Cost Volume Profit Analysis

Introduction

Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorizing production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.

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Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.

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 Questions on CVP Analysis
Question 1
Fahad Corporation has total sales of Rs.4,500,000. Fixed expenses are of Rs.1,200,000 and the
variable cost of Rs.1,800,000.
Required:
1. Contribution Margin
2. Contribution Margin ratio
3. Break-even Point

Question 2
Faisal Corporation has a normal capacity of 18,000 units and the unit sales price is Rs.2.50.
Costs are as under.
Variable Fixed
(Per unit)
Rs. Rs.
Direct Materials 0.700 ---
Direct Labour 0.800 ---
Factory Overheads 0.150 3,000
Non- manufacturing Cost 0.025 1,290
Required:
1. Break-even Point in Rupees
2. Break-even Point in units
3. Sales in rupees required to produce a profit of Rs.8,250.

Question 3
A product has a selling price of Rs. 50 and a unit variable cost of Rs. 30. Fixed Cost for the
period is Rs. 100,000.
You are required:
i. What is the break even point for this product in units?
ii. What is this point in Rupees of Sales.
iii. What Sales Volume in units is needed to earn a target profit of Rs. 50,000.
iv. What Rupees Sales value is needed to achieve to objective stated above.
v. Management would like to earn a target profit of Rs. 50,000 but also increase the
advertising budget by Rs. 60,000 to stimulate sales. What sales volume in units and
Rupees in needed to achieve this objective?
vi. Suppose that Management expected the advertising campaign to increase profit to
Rs.70,000. what sales volume would be required to achieve this objective.
vii. If the unit selling price is reduced by Rs. 5, what sales volume in units would be
needed to break even.
viii. If the unit selling price is reduced by Rs. 5 and variable cost per units is reduced by
Rs. 5, what impact will this have on the unit break even point.
ix. If fixed cost, variable costs, and selling price each are increased by 20 percent. What
sales volume in units and Rupees will be required to earn a target profit of Rs. 40,000.

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Question 4
Dotson Company plans to manufacture and sell 50,000 units per year of a new product. The
following estimates have been made of company’s cost and expenses.

Fixed Variable per unit

Manufacturing Costs:
Direct Materials Rs.47
Direct Labour 32
Manufacturing Overheads Rs. 340,000 4
Period Costs:
Selling Expenses 1
Administrative Expenses 200,000
Total 540,000 84

Required:
1. Compute sales price per unit if Company sets a target profit of Rs.260,000 by producing
and selling 50,000 units.
2. At the unit sales price computed in requirement 1, how many units the Company must
produce and sell to break-even.
3. Compute the margin of safety.

Question 5 (a)
The annual budget of National Tannery shows:
Sales (80,000 units) ---------------------------------------------------------------- Rs.160,000
Fixed Production Cost -------------------------------------------------Rs.40,000
Fixed Marketing Costs ------------------------------------------------ 52,400
Variable Production Cost --------------------------------------------- 38,000
Variable Marketing Cost ---------------------------------------------- 10,000
Total Cost ---------------------------------------------------------------------------- 140,400
Profit --------------------------------------------------------------------------------- 19,600
Required: The Budgeted Profit and New Break-Even Point in rupees assuming that Company
revises the annual budget by increasing the sales price by 5%, which is expected to decrease the
volume by 15%, with variable costs bearing the same relationship to sales in rupees as in the
original annual budget.
(b). If C/M Ratio is 44% and total contribution Margin is Rs.116,600, what is the sales figure?

Question 6 (a).
Malbourn Company has a C/M Ratio of 64%. Break-even Sales are Rs.160,000. The company
earned a profit of Rs.57,600 during the year.
Required:
1. Fixed expenses for the year

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 2. Sales for the year
3. variable expenses for the year
4. Margin of Safety ratio
(b). ATT Company has budgeted sales of Rs.400,000, a profit of Rs.120,000, and fixed expenses
of Rs.80,000.
Required:
The C/M Ratio.

Question 7
Pakistan International Airlines (PIA) flies a number of routes in Pakistan. The airline is obligated
to provide 100 flights per month. Each flight carries 150 passengers. All routes are about the
same distance. Airline fair per passenger is Rs.660. Each flight costs Rs.40,000 for gasoline,
crew salaries etc. Variable per passenger is Rs.60 to cover meal and head tax imposed for each
passenger at every airport to which Airline flies. Other costs (all fixed) are Rs.130,000 per
month.

Required:
1. What is current Break-Even in terms of rupees and number of passengers?
2. How many passengers must the Airline get on its 100 flights in order to earn a monthly
profit of Rs.70,000.