Direct costing method

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Direct costing method definition & example - finance | ToolsHero

This article explains the direct costing method in a practical way. After reading you will understand the basics of this powerful financial management tool.

Introduction direct costing method

There are several methods of cost calculations to calculate costs when it concerns accounting for production-related expenses. In addition to Absorption Costing, Direct Costing is one of the best-known techniques.

Absorption Costing is about accounting for all expenses related to the production of goods or services, where as Direct Costing Method only targets the direct variable costs.

The direct costing method is a practical tool in which the cost calculation is used for making decisions aimed at production and sales planning. This concerns direct costing (of materials and labour) that quickly provide an insight so that a cost calculation or cost indication can be made. This direct calculation of direct costing method can be useful for the management of an organization when decisions have to be made with respect to cost control. Examples are:

Purchasing of equipment

By making efficient investments direct costs can be lowered quickly.

Pricing of products or services

Pricing of products or services can be used for the calculation of break-even prices.

Profitability analysis

Profitability analysis is offsetting of customer purchases minus direct costs so that a company can determine which customers are the most profitable.

Budgeting

Budgeting is setting up of a budgeting system to calculate the budgeted variable cost and the actually achieved sales volumes.

Disadvantages of the direct costing method

Although the direct costing method is a great practical tool, it also has disadvantages. This is because it considers the direct variable costs but not the total costs including overheads. The Direct Costing Method is most useful for short-term situations than for long- term situations. Other situations in which the Direct Costing Method must not be used are:

Long-term prices

Long-term prices for a correct calculation of prices for the long-term it is important that the total costs are considered, meaning the constant costs and overheads so that a good, future-proof pricing can be made. Direct Costing does not make this possible.

Capacity calculations

With respect to the above mentioned matter it is important that if an organization wants to produce a large production unit, it has a good and a balanced picture of the overheads. direct costing only allocates direct labour costs with the consequence that the entire capacity is not passed on to the price per item or service.

Step Costs

Direct costing only considers direct costs, for example per production unit. The moment larger production volumes occur in relation to various necessary facilities such as utility services, space and insurance, these are not covered by the cost accounting from direct costing systems.

Stock valuation

Direct costing cannot be used for stock valuation, as this the Generally Accepted Accounting Principles (GAAP) do not allow this. For Dutch organizations, the successor of GAAP/NL-GAAP is IFRS. This is because under a direct costing system, all costs in addition to the direct costs are charged to the current period.

Calculation example of the direct costing method

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

  • Sales price per piece: 50 euro
  • Direct  material costs per product: 8 euro
  • Direct  labour costs per product: 5 euro
  • Variable production overhead costs per product: 3 euro

Detailed information for the months of March and April

March April
Production of product Y 500 380
Sales of product Y 300 500

There was no initial stock in March. The fixed overhead costs are now budgeted at 4,000 euro a month and have been absorbed per production. A regular production is 400 pieces per month.

Additional costs:

  • Fixed costs for sales: 4,000 euro per month
  • Fixed costs for the administration: 2,000 euro per month
  • Variable costs for sales (commission): 5% of the sales proceeds

Step 1: calculation of full production costs per product based on direct costing

Description costs
Direct  material costs per product   8 euro
Direct labour costs per product   5 euro
Variable  production overhead costs per product   3 euro
Full production costs per product 16 euro

Step 2: calculation of stock value and production

Month Initial stock Production Sales Closing stock Valuation
March 0 pieces 500 pieces -/- 300 pieces 200 pieces 3,200 euro
April 200 pieces 380 pieces -/- 500 pieces 80 pieces 1.280 euro

Step 3: Direct costing profit calculation

March April
Sales 15.000 euro 25.000 euro
Less sales costs
– Initial stock
– Production
– Closing stock
Gross profit
0 euro
8.000 euro
3.200 euro
– 4.800 euro
10.200 euro 3.200 euro
6.080 euro
1.280 euro
– 8.000 euro
17.000 euro
Less costs
– Variable costs for sales (commission)
– Fixed administration costs
– Fixed sales costs
750 euro
2.000 euro
4.000 euro
– 6.750 euro
1.250 euro
2.000 euro
4.000 euro
– 7.250 euro
Net profit 3.450 euro 9.750 euro

 

More information

  1. Garrison, R., Noreen, E. and Brewer. P. (2012). Managerial Accounting (14th ed.). McGraw-Hill.
  2. Kaplan, R. and Bruns, W. (1987). Accounting and Management: A Field Study Perspective. Harvard Business School Press, ISBN 0-87584-186-4.

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