Using direct (marginal) costing for decision making

group: Sepkulova Dina

Tarakanov Dmitry

Kozhevnikova Nadezhda

Shlyaga Nina

What is Direct Costing? The Direct Costing method (Marginal costing) is an inventory valuation / costing model that includes only the variable manufacturing costs: -direct materials (those materials that become an integral part of a finished product and can be conveniently traced into it)

-direct labor (those factory labor costs that can be easily traced to individual units of product. Also called touch labor) - only variable manufacturing overhead in the cost of a unit of product. The entire amount of fixed costs are expenses in the year incurred.

The principles of marginal costing

1. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, selling an extra item of product or service:

� Revenue will increase by the sales value of the item sold

� Costs will increase by the variable cost per unit

� Profit will increase by the amount of contribution earned from the extra item

2. The volume of sales falls by one item � the profit will fall by the amount of contribution earned from the item.

3. Profit measurement should be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs

4. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased

Features of Marginal costing

1.Cost Classification

The marginal costing technique makes a sharp distinction between

variable costs and fixed costs. It is the variable cost on the basis of

which production and sales policies are designed by a firm following the

marginal costing technique

2. Stock/Inventory Valuation

Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method

3. Marginal Contribution

Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments

Cost-volume-profit analysis

•Systematic method of examining the relationship between changes in activity and changes in total sales revenue, expenses and net profit

•CVP analysis is subject to a number of underlying assumptions and limitations

•The objective of CVP analysis is to establish what will happen to the financial results if a specified level of activity or volume f luctuates

CVP analysis assumptions

• All other variables remain constant

• A single product or constant sales mix

• Total costs and total revenue are linear functions of output

• The analysis applies to the relevant range only

• Costs can be accurately divided into their fixed and variable elements

• The analysis applies only to a short-time horizon

• Complexity-related fixed costs do not change

CVP diagram

A mathematical approach to CVP analysis

NP=Px-(a+bx),

NP – net profit

x – units sold

P – selling price

b – unit variable cost

a – total fixed costs

Break-even and related formulas

• TR –Profit = FC + VC

• Contribution = TR – VC

• Profit = Contribution – FC

• Break-even (units) = FC/Contribution per unit

• Break-even (sales revenue) =FC/PV ratio, where PV (profit - volume) ratio = Contribution/Selling price

Margin of safety

Indicates by how much sales may decrease before a loss occurs

Margin of safety (units)= Profit/Contribution per unit

Margin of safety (sales revenue) = Profit/PV ratio

Range of goods planning (1) A B C

1000 1200 1500

per unit total per unit total

per unit total

Price(sales) 35 35 000 40 48 000 25

37 500

120 500

VC 21 21 000 30 36 000 15

23 010

80 010

FC

(allocated) 12 11 618 13

15 934 6

12 448

40 000

Costs 33 32 618 43 51 934 24

35 458

120 010

Prof it 2 2 382 -3 -3

934 1 2 042 490

Contribution 14 14 000 10 12 000 10

14 490

40 490

A B C

1000 0 1500

per unit total per unit total

per unit total

Price(sales) 35 35 000 0 0 25 37 500

72 500

VC 21 21 000 0 0 15 23 010

44 010

FC

(allocated) 19 19 310 0 0 6

20 690

40 000

Costs 40 40 310 0 0 29 43 700

84 010

Prof it -5 -5 310 0 0 -4 -6

200 -11 510

14 28

Increases in activity level (unlimited)

A B C

2500 1200 1500

per unit increment total per unit total per unit total

Price(sales) 35 +52500 87 500 40 48 000 25 37 500 173 000

VC 21 +31500 52 500 30 36 000 15 23 010 111 510

FC (allocated) 12 +10000 11 618 13 15 934 6 12 448 50 000

Costs 33 64 118 43 51 934 24 35 458 161 510

Profit 2 +9150 23 382 -3 -3 934 1 2 042 11 490

Contribution 14 35 000 10 12 000 10 14 490 61 490

Increases in activity level (limited)

A B C

1000 1200 1500

per unit total per unit total per unit total

Price(sales) 35 35 000 40 48 000 25 37 500 120 500

VC 21 21 000 30 36 000 15 23 010 80 010

FC (allocated) 12 11 618 27 31 871 8 12 448 40 000

Costs 33 32 618 57 67 871 24 35 458 120 010

Profit 2 2 382 -17 -19 871 1 2 042 490

Contribution 14 14 000 10 12 000 10 14 490 40 490

Number of labour hours used 3 3 2

Contribution per hour 4,67 3,33 4,83

Rank 2 3 1 max hours

Demand in units 6000 7000 6000 19000

Total labour demand 7000 0 12000

Pricing Price is 250 $ per unit

choice 1 better quality (higher price,higher FC)

choice 2 lower price

1 2

10 000 12 000

per unit total per unit total

Price(sales) 300 3 000 000 200 2 400 000

VC 100 1 000 000 80 960 000

FC (allocated) 3 000 2 400

Costs 100 1 003 000 80 962 400

Profit 200 1 997 000 120 1 437 600

Contribution 200 2 000 000 120 1 440 000

BEP 15 000 20 000

Capacity 25 000 25 000

To produce or to buy

Produce Buy (unlimited)

1000 1000

per unit total per unit total

Price 150 150000 150 150000

VC 50 50000 x x

FC (allocated) 100000 x x

Costs 50 150000 150 150000

Profit 100 0 0 0

Produce Buy (unlimited)

1200 1200

per unit total per unit total

Price(sales) 150 180000 150 180000

VC 50 60000 x x

FC (allocated) 100000 x x

Costs 50 160000 150 180000

Profit 100 20000 0 0

Advantages

• Direct costing is simple to understand

• It provides more useful information for decision-making

• Direct costing removes from profit the effect of inventory changes

• Is effective in internal reporting for frequent profit statements and measurement of managerial performance

• Direct costing avoids fixed overheads being capitalized in unsaleable stocks

• The effects of alternative sales or production policies can be easier assessed thus the decisions yield the maximum return to business

• By concentration on maintaining a uniform and consistent marginal cost practical cost control is greatly facilitated

Disadvantages

• The separation of costs into fixed and variable is difficult and sometimes gives misleading results

• Direct costing underestimates the importance of fixed costs

• Full costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by direct costing

• Under direct costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent

• Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.

Disadvantages (2)

• Application of fixed overhead depends on estimates and there may be under or over absorption of the same

• Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing

• In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer

Direct vs. Absorption (full) costing

Direct costing

are regarded as period costs(written

as a lump sum to the profit and loss

account)

are assigned to the products

are period costs

are added to the variable

manufacturing cost of sales to

determine total manufacturing costs

Absorption costing

are allocated to the products (included in inventory valuation)

are assigned to the products

are period costs

are assigned to the products

Fixed manufactured overheads

Variable manufacturing costs

Non-manufacturing overheads

Fixed manufacturing costs

Direct vs. Absorption (full) costing

Direct costing

• Profit is a function of sales

• Are recommended where indirect costs are a low proportion of an organization’s total costs

• is used for managerial decision-making and control

• used mainly for internal purposes

Absorption costing

• Profit is a function of both sales and production

• Assigns indirect costs to cost objects

• is widely used for cost control purpose esp. in the long run

• consistent for external reporting

Thank you for attention!!