Direct Costing

Direct Costs
Direct Costs are direct materials, direct labour and other costs directly assignable to a product.

Direct (Marginal) Costing

Direct costing is a procedure by which only prime costs plus variable FOH are assigned to the
product or inventory; all fixed costs are considered period costs.

Period Costs VS Product Costs

Period Costs
Period costs are charged against the income of the current period. In direct costing, fixed FOH as
well as selling and administrative expenses are treated as period costs.

Product Costs

Costs that apply to the production of goods are called period costs. Variable manufacturing costs
(Direct Materials, Direct Labour and Variable FOH) are typical product costs in Direct Costing
and are charged against the income when the units to which they relate are sold.

Marginal Costing VS Absorption Costing

Marginal (Direct Costing)
Marginal costing is a costing procedure in which only variable manufacturing costs are charged
to the products and inventory, while fixed manufacturing costs become period costs.

Absorption Costing
Absorption costing is a costing procedure which assigns Direct Materials, Direct Labour and a
share of both fixed and variable FOH to units of production.

Marginal(Differential) Cost
Marginal cost is the additional cost of producing an additional unit.

1
INVENTORY VALUATION METHODS: ABSORPTION vs. VARIABLE COSTING

The distinction between absorption and variable costing is based on the treatment of fixed

overhead.

 Under absorption costing, fixed overhead is assigned to units of inventory and shows up

in the income statement as part of the CGS when the units are sold. When units are

produced and not sold, fixed overhead stays in finished goods inventory

Absorption costing includes fixed manufacturing overhead in inventoriable costs

 Under variable costing, no fixed overhead is assigned to inventory. Fixed overhead is a

period expense which enters the income statement as a line-item every period regardless

of the number of units sold.

Variable costing excludes fixed manufacturing overhead from inventoriable costs.

Format (Technical) Differences

 Absorption costing makes a primary classification of costs according to manufacturing

and non-manufacturing functions, emphasizing the gross margin (that is, Sales - CGS)

available to cover all fixed and variable selling and administrative expenses.

 Direct costing makes a primary classification of costs into variable and fixed categories,

emphasizing the contribution margin (that is, sales - variable costs) available to cover all

fixed costs.

2
Report Formats

The formats for profit reporting under direct costing and absorption costing are different.

Absorption Costing Direct Costing

Revenues Revenues
- -
Cost of Goods Sold Variable Manufacturing
------------------ -
Gross Margin Variable S&A
- -------------------
Variable S&A Contribution Margin
- -
Fixed S&A Fixed Manufacturing
----------------- -
Profit Fixed S&A
======= -------------------
Profit
========

The figures under the two approaches will not always be the same.

Interpretation of the Difference

The difference between the two income-measurement approaches is essentially the difference in

the timing of the charge to expense for fixed factory-overhead cost. In the absorption-costing

method, fixed factory overhead is first charged to inventory; thus, it is not charged to expense

until the period in which the inventory is sold and included in cost of goods sold (an expense).

In contrast, in the variable-costing method, fixed factory overhead is charged to expense

immediately, and only variable manufacturing costs are included in product inventories.

Therefore, if inventories increase during a period (i.e., production exceeds sales), the

variable-costing method will generally report less operating income than will the

absorption-costing method; when inventories decrease, the opposite effect will take place.

3
Example 1
Assume the following (per unit)

Direct Materials 2.5 lbs @ $4.00 $10.00

Direct Labor .5 hr @ $16.00 $ 8.00

VOH .5 hr @ $4.00 $ 2.00

FOH $40,000 $ 2.50

Actual Output 16,000 units

Variable S&A $6.00 per unit

Fixed S&A $60,000

Selling price $40

What do the income statements look like if actual sales equal 16,000 units?

Absorption Costing Direct Costing

Revenue (40)(16000) 640,000 Revenue (40)(16000) 640,000

Cogs (22.50)(16000) 360,000 Vbl Mfg (20)(16000) 320,000

GM (17.50)(16000) 280,000 Vbl S+A (6)(16000) 96,000

Vbl S+A (6)(16000) 96,000 CM 224,000

Fx S+A 60,000 Fx Mfg 40,000

Profit 124,000 Fx S+A 60,000

Profit 124,000

- Note: When sales equals production, profit under absorption costing and direct costing are

equal.

4
Example 2

Assume sales of 12,000 units. What is the profit under each costing method?

Absorption Costing Direct Costing

Revenue (40)(12000) 480,000 Revenue (40)(12000)

480,000

Cogs (22.50)(12000) 270,000 Vbl Mfg (20)(12000)

240,000

GM (17.50)(12000) 210,000 Vbl S+A (6)(12000)

72,000

Vbl S+A (6)(12000) 72,000 CM (14)(12000)

168,000

Fx S+A 60,000 Fx Mfg

40,000

Profit 78,000 Fx S+A

60,000

Profit

68,000

- Note: When production exceeds sales, absorption profit exceeds direct

profit.

Example 3

Assume sales of 18,000 units. What is the profit under each costing method?

5
 Absorption Costing Direct Costing

Revenue (40)(18000) 720,000 Revenue (40)(18000)

720,000

Cogs (22.50)(18000) 405,000 Vbl Mfg (20)(18000)

360,000

GM (17.50)(18000) 315,000 Vbl S+A (6)(18000)

108,000

Vbl S+A (6)(18000) 108,000 CM (14)(18000)

252,000

Fx S+A 60,000 Fx Mfg

40,000

Profit 147,000 Fx S+A

60,000

Profit

152,000

- Note: When sales exceed production, direct profit exceeds absorption

profit.

Question 1
The ATT Corporation produced 24,000 units (normal capacity) of product
during the first quarter of the year. 20,000 units were sold at Rs.22 per unit.
The costs of this production were:

Direct Materials Rs. 60,000

Direct Labour 60,000
Factory Overheads:
Fixed 96,000
Variable 120,000

6
Fixed marketing and Admin. expenses for the quarter were Rs.70,000.

Required:
1. An Income Statement using Absorption Costing.
2. An Income Statement using Marginal Costing.

Question 2
The following information is available from the books of DG Corporation:

Rs.
Sales Price per Unit -----------------------------------------------------------------
30
Variable manufacturing cost per unit----------------------------------------------
8
Total Annual Fixed manufacturing cost-------------------------------------------
50,000
Variable administrative cost per unit-----------------------------------------------
3
Total annual fixed administrative cost---------------------------------------------
30,000

There was no inventory at the beginning of the year. Normal capacity is

25,000 units. During the year, 25,000 units were produced and 22,000 units
were sold.

Required:
1. Ending inventory, assuming the use of absorption costing.
2. Ending inventory, assuming the use of marginal costing.
3. Total variable cost charged to expense for the year, assuming the
use of Direct costing.
4. Total fixed cost charged to expense for the year, assuming the use
of absorption costing.

7
 Cost Volume Profit Analysis

Introduction

Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorizing production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.
Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.
 Questions on CVP Analysis
Question 1
Fahad Corporation has total sales of Rs.4,500,000. Fixed expenses are of Rs.1,200,000 and the
variable cost of Rs.1,800,000.
Required:
1. Contribution Margin
2. Contribution Margin ratio
3. Break-even Point

Question 2
Faisal Corporation has a normal capacity of 18,000 units and the unit sales price is Rs.2.50.
Costs are as under.
Variable Fixed
(Per unit)
Rs. Rs.
Direct Materials 0.700 ---
Direct Labour 0.800 ---
Factory Overheads 0.150 3,000
Non- manufacturing Cost 0.025 1,290
Required:
1. Break-even Point in Rupees
2. Break-even Point in units
3. Sales in rupees required to produce a profit of Rs.8,250.

Question 3
A product has a selling price of Rs. 50 and a unit variable cost of Rs. 30. Fixed Cost for the
period is Rs. 100,000.
You are required:
i. What is the break even point for this product in units?
ii. What is this point in Rupees of Sales.
iii. What Sales Volume in units is needed to earn a target profit of Rs. 50,000.
iv. What Rupees Sales value is needed to achieve to objective stated above.
v. Management would like to earn a target profit of Rs. 50,000 but also increase the
advertising budget by Rs. 60,000 to stimulate sales. What sales volume in units and
Rupees in needed to achieve this objective?
vi. Suppose that Management expected the advertising campaign to increase profit to
Rs.70,000. what sales volume would be required to achieve this objective.
vii. If the unit selling price is reduced by Rs. 5, what sales volume in units would be
needed to break even.
viii. If the unit selling price is reduced by Rs. 5 and variable cost per units is reduced by
Rs. 5, what impact will this have on the unit break even point.
ix. If fixed cost, variable costs, and selling price each are increased by 20 percent. What
sales volume in units and Rupees will be required to earn a target profit of Rs. 40,000.
Question 4
The city bottling company provides a variety of bottles drinks the company has classified
product in to three basic categories:

Selling price variable

Per unit per unit
Coca cola Rs. 1.50 Rs. 1.40
Fanta 1.20 1.00
Tarimo 1.00 0.40

The fixed cost of the company are Rs. 38,000 annually and do not change with any change in
product mix nor with total volume changes of less than 50 percent. During 2003 sales of coca
cola brands amounted for 50percent of the company’s total sales in unit sales of fanta brands
were four times that of Tarimo brands. Total sales revenue for the year 2003 was Rs. 500,000

Required:
1) The breakeven point in Rupees and in units of each product group for 2003 on the
actually experienced sales mix.
2) The amount which could be spend for advertising in 2004 to increase sales of the
more profit and lines so that the Fanta sales would amount for 50 percent of sales in
case Tarimo 20 percent and Coca cola 30percent with the company still making profit
of one and on half times that of 2003 on the same total sales revenue.

Question 5
Dotson Company plans to manufacture and sell 50,000 units per year of a new product. The
following estimates have been made of company’s cost and expenses.

Fixed Variable per unit

Manufacturing Costs:
Direct Materials Rs.47
Direct Labour 32
Manufacturing Overheads Rs. 340,000 4
Period Costs:
Selling Expenses 1
Administrative Expenses 200,000
Total 540,000 84

Required:
1. Compute sales price per unit if Company sets a target profit of Rs.260,000 by producing
and selling 50,000 units.
2. At the unit sales price computed in requirement 1, how many units the Company must
produce and sell to break-even.
3. Compute the margin of safety.
Question 6 (a)
The annual budget of National Tannery shows:
Sales (80,000 units) ---------------------------------------------------------------- Rs.160,000
Fixed Production Cost -------------------------------------------------Rs.40,000
Fixed Marketing Costs ------------------------------------------------ 52,400
Variable Production Cost --------------------------------------------- 38,000
Variable Marketing Cost ---------------------------------------------- 10,000
Total Cost ---------------------------------------------------------------------------- 140,400
Profit --------------------------------------------------------------------------------- 19,600
Required: The Budgeted Profit and New Break-Even Point in rupees assuming that Company
revises the annual budget by increasing the sales price by 5%, which is expected to decrease the
volume by 15%, with variable costs bearing the same relationship to sales in rupees as in the
original annual budget.
(b). If C/M Ratio is 44% and total contribution Margin is Rs.116,600, what is the sales figure?

Question 7 (a).
Malbourn Company has a C/M Ratio of 64%. Break-even Sales are Rs.160,000. The company
earned a profit of Rs.57,600 during the year.
Required:
1. Fixed expenses for the year
2. Sales for the year
3. variable expenses for the year
4. Margin of Safety ratio
(b). ATT Company has budgeted sales of Rs.400,000, a profit of Rs.120,000, and fixed expenses
of Rs.80,000.
Required:
The C/M Ratio.

Question 8
Pakistan International Airlines (PIA) flies a number of routes in Pakistan. The airline is obligated
to provide 100 flights per month. Each flight carries 150 passengers. All routes are about the
same distance. Airline fair per passenger is Rs.660. Each flight costs Rs.40,000 for gasoline,
crew salaries etc. Variable per passenger is Rs.60 to cover meal and head tax imposed for each
passenger at every airport to which Airline flies. Other costs (all fixed) are Rs.130,000 per
month.

Required:
1. What is current Break-Even in terms of rupees and number of passengers?
2. How many passengers must the Airline get on its 100 flights in order to earn a monthly
profit of Rs.70,000.
Question 9
ABC Company manufactures a product which sells for Rs.5. At present, the company produces
and sells 50,000 units per year. Unit variable manufacturing and marketing expenses are Rs.2.50
and Rs.0.50 respectively. Fixed FOH are Rs.70,000 and Fixed Marketing Expenses are
Rs.30,000.

Proposal: The sales manager has proposed that the sales price be increased to Rs.6 per unit. To
maintain the present sales volume, advertisement must be increased. The company’s profit
objective is 10% of sales.

Required:
1. What is current breakeven point in units and rupees?
2. The additional expenditure the company can afford for advertising under the proposal.
3. The new Breakeven point in units and rupees, using the Rs.6 sales price and the
additional advertising expenditure, calculated in requirement 2.

Question 10

Z Ltd manufactures and sells three products with the following selling prices variable costs:

Product A Product B Product C

Rs. Rs. Rs.
Selling price 3.00 2.45 4.00
Variable cost 1.20 1.67 2.60

The company is considering expenditure on advertising and promotion of product A. It is hoped

that such expenditure together with a reduction in the selling price of the product would increase
sales. Existing annual sales volume of the three products is:

Product A 460 000 UNITS

Product B 1 000 000 UNITS
Product C 380 000 UNITS

If Rs 60000 per annum was to be invested in advertising and sales promotion, sales of product A
at reduced selling prices would be expected to be:

590000 units at Rs. 2.75 per unit or

650000 units at Rs. 2.55 per unit

Annual fixed costs are currently Rs 1710000 per annum.

Required:
a) Calculate the current break-even sales revenue of the business.
b) Advise the management of Z Ltd as to whether the expenditure on advertising and
promotion, together with selling price reduction should be introduced on product A.