Direct Costing Method explained

Direct Costing Method: this article explains the Direct Costing Method in a practical way. The article contains the definition and basic explanation of this method, including examples of situations where this calculation method is valuable. You will also find advantages and disadvantages of this method. Enjoy reading!

What is the Direct Costing Method (DCM)?

Direct Costing Method is a costing technique used in managerial accounting, where only direct costs are considered while determining the total cost of production. This method focuses on the variable costs that are directly related to the production of a product or service.

Direct costs are costs that can be easily traced to a specific product or service, such as the cost of raw materials, direct labor, and direct expenses. The direct costing method does not consider fixed costs like rent, depreciation, and administrative expenses, since these costs are not directly related to the production of a product or service.

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Using the direct costing method, the cost of a product or service is determined by adding the direct material cost, direct labor cost, and direct expenses. This method is useful for short-term decision making and in situations where it is difficult to allocate fixed costs to specific products or services.

It is important to note that the direct costing method is not recognized under generally accepted accounting principles (GAAP) and is not suitable for financial reporting purposes. Instead, it is used primarily for internal management decision making.

The formula for DCM is as follows:

Total Cost = Direct Materials + Direct Labor + Direct Expenses

Direct Materials are the costs of raw materials or components that are used to produce the product or service
Direct Labor is the cost of labor required to produce the product or service
Direct Expenses are the other direct costs associated with producing the product or service, such as shipping or packaging costs

Situations in which the Direct Costing Method can be used

Pricing decisions

Suppose you are running a small business that produces handmade jewelry. You need to determine the selling price of a bracelet that you produce. By using the direct costing method, you can determine the direct costs of producing the bracelet, including the cost of materials, labor, and other direct expenses. You can then add a markup to the direct costs to arrive at a selling price that covers your costs and provides a profit.

Special orders

Imagine that your small business receives a special order for a large quantity of a specific product that you do not usually produce. By using the direct costing method, you can calculate the direct costs of producing the product, such as the cost of materials, labor, and other direct expenses. You can then compare the direct costs to the revenue generated by the special order to determine if it is profitable.

Cost-volume-profit analysis

If you are running a business that has significant variable costs, such as a restaurant, the direct costing method can be useful in conducting cost-volume-profit analysis. This analysis involves examining how changes in sales volume can impact your costs and profits. By using the direct costing method, you can easily determine your variable costs, which can help you understand how changes in sales volume will affect your profitability. This can help you make informed decisions about pricing, promotions, and other business decisions.

Example calculation Direct Costing Method

Let’s say that company X produces and sells widgets. The direct costs associated with producing each widget are as follows:

Direct materials: $5
Direct labor: $3
Direct expenses: $2

Using the direct costing method, the total cost of producing one widget would be:

Total Cost = Direct Materials + Direct Labor + Direct Expenses Total Cost = $5 + $3 + $2 Total Cost = $10

In this case, the company would only consider the direct costs of producing each widget and would not include any fixed costs, such as rent, salaries, or advertising expenses.

If the company sells each widget for $15, then the gross profit per widget using the direct costing method would be:

Gross Profit = Selling Price – Total Cost Gross Profit = $15 – $10 Gross Profit = $5

Therefore, the company would earn a gross profit of $5 for each widget sold using the direct costing method.

Disadvantages of the Direct Costing Method

Although the DCM 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. This calculation method is most useful for short-term situations than for long- term situations.

Other situations in which this method must not be used are:

DC: 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. This method does not make this possible.

Capacity calculations in DCM

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.

This method 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

DC 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 DC systems.

Stock valuation

DC 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.

Summary Direct Costing Method

The Direct Costing Method is a costing method used in cost accounting to determine the cost of producing goods or services. This method only considers the variable manufacturing costs involved in the production of goods, such as direct materials, direct labor, and direct expenses.

It excludes fixed costs and administrative expenses, which are considered indirect costs. This method is useful in determining the profitability of a specific product and how it will affect the overall financial health of a company. It is also useful in determining how the increase or decrease in production levels or sales volumes will affect the cost of production.

In contrast, Absorption Costing considers all costs, including fixed costs and administrative expenses, in the production of goods. The Direct Costing Method is commonly used in product departments to determine the cost of producing a specific product.

Now it’s your turn

What do you think? Do you use this costing method? Or do you prefer other methods for costing, like absorption costing? Do you recognize this explanation, or do you have suggestions? What are your tips for effective financial management?

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More information

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

How to cite this article:
Van Vliet, V. (2012). Direct Costing Method. Retrieved [insert date] from Toolshero: https://www.toolshero.com/financial-management/direct-costing/

Originally published on: 06/09/2012 | Last update: 05/03/2023

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