Advocacy of direct costing has a long history in accounting and finance. The national association of accountants has long favored the use of direct costing and as far back as 1936 issued research reports and other publications pointing out the advantages of direct costing. The rapid expansion of the work of many CPA firm’s management advisory services divisions is due in part to the installation of direct costing systems. Much of this work had long been carried out by specialized management consulting firms. It might be pointed out that the advantages or disadvantages do not actually relate to internal use or external use, but rather to the method itself. For many years, companies using absorption costing have made analyses of direct and indirect costs and have prepared break-even charts. However, the necessary data required special studies because the information was not readily available in the accounts as it is in direct costing.
This post provides a fair overview on advantages and disadvantages of direct costing. By knowing the advantages and disadvantages, you would be able to decide whether to implement direct costing or not. First, let’s see what the advantages are, then followed by its disadvantages. Read on…
Advantages of Direct Costing
The advantages of direct costing have generally been well recognized by top CFOs, production managers, marketing managers, and cost analysts. Direct costing overcomes the principal problem of absorption costing, that is, the distortion of the time relationship of “sales”, “cost of goods sold”, and “net income”. Following are the principal advantages of direct costing:
Advantage#1. Operations Planning
The plan of operations, or master budget plan, covers all aspects of future operations designed to reach an established profit goal. Direct costing facilitates the compilation of profit-planning data, which cost departments have always developed—often at a great expenditure of time and effort, long before the advent of the present direct costing structures. The readily available data on variable cost and contribution margin permits quick answers to the scores of cost decisions that management must make each day, such as the installation of a new machine or special cost center. Reliable estimates of unitized variable costs and total fixed costs can be readily provided by direct costing.
If variable costs are $14 per unit, which is expected to be 70% of the unit sales price of $20, in line with similar products, and the total fixed costs are $45,000, the following quick feasibility computation can be made. The unit sales are projected to be 20,000 per year.
Per Unit Total Amount Percent
Sales (20,000 units) $20 $400,000 100%
Variable costs $14 $280,000 70%
Contribution margin $6 $120,000 30%
Fixed costs $ 45,000 11.2%
Net operating income $ 75,000 18.8%
The key to the above computation is the variable cost of $14. The product would have to sell at $20, in accordance with the general pricing policy of variable cost being 70% of selling price ($14 / 70% = $20). The marketing department estimates that annual sales would be approximately 20,000 units. With $400,000 sales, the net operating income would be $75,000, or 18.8% of sales. The project would be worth exploring further, since the net operating income percentage comfortably exceeds the break-even point analysis.
Advantage#2. Cost-Volume-Profit Analysis
A great many applications involving break-even analysis or cost-volume analysis are continually used by management in the day-to-day operations of a manufacturing company. Most managerial decisions are cost-related, and an understanding of these relationships is essential.
There are simple computations to determine the break-even point after the contribution margin and fixed costs are known. The break-even point is the sales volume at which there will be neither a profit nor a loss. Great many applications involving break-even analysis or cost-volume analysis are continually used by management in the day-to-day operations of a manufacturing company. Most managerial decisions are cost-related, and an understanding of these relationships is essential.
There are simple computations to determine the break-even point after the contribution margin and fixed costs are known. The break-even point is the sales volume at which there will be neither a profit nor a loss. Below this level a loss will occur; above this level a profit will be earned. The break-even point is where the total contribution margin is equal to the total fixed expenses.
Advantage#3. Management Decisions
An adequate direct cost system will, of necessity, have to provide for the proper segregation of fixed and variable costs. Mixed costs will have been separated into fixed and variable components, and thus a convenient system is provided for accumulation and evaluation of costs. Forecasting of costs and contribution margins, flexible budget analysis, relationship of costs to sales volume and sales price, and many other cost relationships can be readily studied. The direct cost income statement will enable management to see and understand the effect that period costs have on profits and will facilitate better decision making.
Advantage#4. Product Pricing
Marketing department managers have been using variable costing in setting selling prices for many years. The understanding of contribution margin and sales pricing is one of the first things they must learn if they are to be successful.
Retailers know they must add a given percentage to cost to arrive at selling price. The contribution margin (sales minus variable costs) must be large enough to cover all fixed expenses such as salaries, rent, and taxes and also provide a reasonable income and an adequate return on investment. Of course, retailers cannot arrive at unrealistic selling prices because their competitors may have lower selling prices. The law of supply and demand will come into operation. If the price is too high, customers will not buy and the inventory will not move. Therefore, retailers will have to lower the selling price by reducing their rate of markup; and if the final return is to be maintained, they will have to reduce variable and/or fixed costs—a difficult task, at best.
Advantage#5. Management Control
The reports based on direct costing are far more effective for management control than those based on absorption costing. First, 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.
The variable cost of sales changes in direct proportion with volume. The distorting effect of production on profit is avoided, especially in a period following high production when substantial amounts of fixed costs are carried in inventory over to the next period. A marked increase in sales in the period after high production under absorption costing will have a significant negative impact on the net operating proit as inventories are liquidated.
Direct costing can help to pinpoint responsibility according to organizational lines; individual performance can be evaluated on reliable and appropriate data on the basis of current period activity. Operating reports can be prepared for all segments of the company, with costs separated into fixed and variable and the nature of any variance clearly shown. The responsibility for costs and variances can then be more readily attributed to specific individuals and functions, from top management on down.
Next, what the disadvantages of direct costing.
Disadvantages Of Direct Costing
The principal disadvantage of direct costing is its lack of acceptance for external reporting by the American institute of Certified Public accountants (predecessor of the Financial Accounting Standards Board), the Internal Revenue Service, and the Securities and Exchange Commission. Their opposition is highlighted as follows:
American Institute of Certified Public Accountants – According to AICPA Accounting Research Bulletin No. 43:
The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.
This section also states that “it should also be recognized that the exclusion of all overheads from inventory does not constitute an accepted accounting procedure”.
The Financial Accounting Standards Board in its Interpretation No. 1 has supported the AICPA position.
Internal Revenue Service [IRS] – Under IRS regulations, certain costs must be included or excluded from inventory for income tax reporting depending on their treatment for financial reporting, “but only if such treatment is not inconsistent with generally accepted accounting principles”. Therefore, firms using direct costing must adjust inventories and net income to what they would have been under absorption costing for income tax purposes.
Securities and Exchange Commission [SEC] – The SEC also does not accept financial reports prepared under the direct costing method. Primarily this lack of acceptance is because direct costing is not a generally accepted accounting procedure. It is also an SEC policy to encourage consistency in financial reporting. The reports of firms using direct costing must also be adjusted for inventories and net income to what they would have been if absorption costing had been used.
The opponents of direct costing argue that while direct costing appears theoretically attractive, it cannot be reliably achieved in practice. For example, there are a number of mixed costs that cannot be readily separated into variable and non-variable costs.
However, this argument against direct costing is on weak grounds. There are statistical techniques and other methodologies that can be employed that allow management to obtain a reasonable estimate of the variable and non-variable components. Breakdown of the components using these methodologies is at least as good as, if not more reliable than, the large number of arbitrary distributions of many indirect costs made in absorption costing that are only slightly related to manufacturing.
Direct costing has come of age and is proving to accountants to be an extremely valuable tool in planning and controlling operations in many large industrial companies. Though still not as widely employed as absorption costing, it is steadily gaining in use. Direct costing product costs include only those manufacturing costs that are closely related to the product and vary with production volume. At present there is disagreement among accountants on the use of direct costing in external reports because of the exclusion of fixed factory overhead costs from inventories and its effect on net income. However, there is little doubt among accountants that direct costing is better suited for internal management purposes in planning, control, and decision making.