What does it really cost to produce or distribute your present line, whether
it consists of toys, gift items, wrenches, sweatshirts or plastic blocks?
How much should you charge for each item? How many do you have to sell to
break even? To make a profit? To make the maximum profit that the
marketplace will accept? If you're not selling enough of a particular
product, should you lower the price, discontinue the item, redesign it, or
replace it with another?
These are typical short-term problems that you as business executives face every day. While there is no single "right" answer, we believe there is a rational, intelligent approach that will get you moving in the right direction. It is called DIRECT COSTING, and it is a simple but powerful management tool that can help your company to maximize its profits.
Direct costing can be best understood by comparing it to the conventional method of treating costs known as absorption costing. Under absorption costing, a portion of fixed costs (that is, items such as rent, utilities, maintenance etc.), which are typically committed for a relatively long time period, are included in the variable short-term costs of producing a product. However, by allocating such indirect fixed or nearly fixed costs to the direct variable costs of a product, management distorts the decision-making process.
A much better approach for management purposes is to use direct costing, which treats these indirect expenses in a totally different way. It counts as the direct costs of manufacturing a product only those out-of-pocket expenditures, which were made or incurred to produce and sell the product; put another way, direct costs are those costs, which disappear if the product is no longer made.
In the case of a manufacturer, direct costs would include the cost of the material and the labor involved in making the product: indirect costs, for items such as machinery, the plant foreman, the company president and support staff, would not be counted because they would continue to be a company expense even if the product were not manufactured.
For the manufacturer, the result of adopting a direct costing system might be the discovery that making one product contributes relatively few dollars per unit toward the company's gross profits, while making a more complex product contributes far more. Indeed, the information provided by a direct costing system might lead to an entirely different product mix than that suggested by an absorption costing system.
By using direct costing, the manufacturer can determine the amount contributed by each product and then rank products according to their total dollar-contribution to overhead. Products with little or no contribution could be redesigned or eliminated, while production of products with a significant contribution could be increased. Of course, the total estimated dollar-contribution of all products must cover the company's overhead and produce a profit. Otherwise, the company must switch gears and chance selling prices or estimated quantities, reduce overhead or product costs, or revise its product mix.
Direct costing can also be used to determine the amount of dollar-contribution per scarce resource. For example, manufacturing one product line might require one hour of large machine time (a scarce resource) and might contribute $100 per hour of machine time; manufacturing another product line might require the same amount of machine time but contribute $125. Faced with maximizing the use of a finite, expensive resource - the large machine - the manufacturer clearly would do better producing the second line.
Time and again, we have found instances where conventional absorption costing indicated a product was not profitable, while direct costing found that it was making a significant contribution to overhead.
To sum up, the virtue of direct costing is that it separates fixed long-term costs, which a company incurs no matter what products it is making, from variable short-term costs, which are highly dependent upon product mix. In effect, direct costing separates the cost of doing business from the cost of being in business.
This is not to say that there is no role for absorption costing in business. Even though direct costing is a vital tool that enables management to make sound, informed decisions, it is an accounting system for internal use only. Absorption costing remains the traditional format for a company's external financial statements.
If your company is not already using this powerful management tool, please contact us. We would be delighted to help you implement a new cost accounting system that will provide you with financial information in the form you need, at the time you need it. Send a message to firstname.lastname@example.org?subject=Direct_Costing_Help
About the author:
George Matyjewicz, PhD is Global Strategist of GAP Enterprises, Ltd. His dissertation “Just In Time Payments And The New Global Currency For Conducting Business In A Global Economy” was compiled from 3+ decades experience in the business world. He was formerly President/General Manager of a global digital currency company with customers in 190 countries and Chief E-Commerce Officer for a global giftware company where he experienced risk management issues first hand. He was a Principal/Partner at a top 20 U.S. CPA/Consulting firm. He is regularly published as an expert on global business, finance, technology and implementation and writes and publishes E-Tailer’s Digest online and in print, which reaches retailers in 37 countries worldwide.