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Direct Costing

Direct Costing

A direct cost is a cost that is directly associated with changes in production volume. This restricts the definition of direct costs to direct materials and direct labor.

Example
The materials used to create a product are a direct cost, whereas the machine used to convert the materials into a finished product is not a direct cost, because it is still going to be sitting on the factory floor, irrespective of any changes in production volume.

Facets of Direct Costing


Profit Planning Internal Use Product Pricing Decision Making

Direct Costing

Cost Control Costing of Inventory External Use Income Determination Financial Reporting

Internal Uses
Profit Planning
Profit plan often called a budget or a plan of operations. Includes both short and long range operations. Useful in planning, pricing and in making decisions. Direct costing as a tool of planning and evaluating profit.

Internal Use
Product Pricing
Prices will be regulated through supply and demand. In multi product pricing management need to know In making pricing decisions the useful part of unit cost is the direct cost segment since it consists of those cost element that are comparable among firms in the same industry.

Internal Use
Decision Making
The direct costing method isolate the fixed and variable cost. The classification of costs as either fixed or variable, with semi variable expenses properly subdivided into their fixed and variable components, which provide a frame work for accumulation and analysis of costs.

Internal Use
Decision Making (Contd.)
This provide a basis for the study of contemplated change in production level or proposed action concerning new market, plant expansion or contraction, or special promotional activities.

Internal Use
Control Tool
The direct costing is said to be the product of incomprehensible income statement prepared for management. The reports based on direct costing are far more effective for management control than those based on absorption costing. The reports are more directly related to the profit objective or budget for the period. Deviations from standards are more readily apparent and can be corrected more quickly.

Internal Use
Control Tool(Contd.) The marketing manger should receive a statement placing sales and production costs in direct relationship to one another & difference between intended sales and actual sales caused by changes in sales price.

Two Costing Method


Absorption Costing
Used for external financial reporting Includes direct materials, direct labor, variable factory overhead, and fix factory overhead as part of total product cost.

Direct Costing
Used for internal planning and decision making Does not include factory overhead(Fix.) as a product cost

Absorption Costing Compared to Direct Costing


Absorption Costing
Cost of Goods Manufactured

Direct Materials

Direct Labor

Variable Factory OH

Fixed Factory OH

Cost of Goods Manufactured

Period Expense

Direct Costing

Units Manufactured Equal Units Sold


Direct Costing Income Statement Sales (15,000 x $50) Variable cost of goods sold: Variable cost of goods mfg. (15,000 x $25) $375,000 Less ending inventory 0 Variable cost of goods sold Variable Gross profit Variable selling and administrative expenses (15,000 x $5) Contribution margin Fixed costs: Fixed manufacturing costs $150,000 Fixed selling and administrative expenses 50,000 Income from operations $750,000

375,000 $375,000 75,000 $300,000

200,000 $100,000

Units Manufactured Equal Units Sold


Absorption Costing Income Statement
Sales (15,000 x $50) Cost of goods sold: Cost of goods manufactured (15,000 x $35) Less ending inventory Cost of goods sold Gross profit Selling and administrative expenses ($75,000 + $50,000) Income from operations $750,000

$525,000 0
525,000 $225,000 125,000 $100,000

When the number of units manufactured equals the number of units sold, income from operations will be the same under both methods.

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