using direct (marginal) costing for decision making
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Using direct (marginal) costing for decision making. group: Sepkulova Dina Tarakanov Dmitry Shlyaga Nina Kozhevnikova Nadezhda. What is Direct Costing?. - PowerPoint PPT PresentationTRANSCRIPT
Using direct (marginal) costing for decision makinggroup: Sepkulova Dina
Tarakanov DmitryShlyaga Nina Kozhevnikova Nadezhda
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 overheadin the cost of a unit of product. The entire amount of fixed costs are expenses in the year incurred.
The principles of marginal costing1. 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 item2. 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 costing1.Cost ClassificationThe marginal costing technique makes a sharp distinction
betweenvariable costs and fixed costs. It is the variable cost on the basis ofwhich production and sales policies are designed by a firm
following themarginal costing technique
2. Stock/Inventory ValuationUnder 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 ContributionMarginal 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 fluctuates
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 profitx – units soldP – selling priceb – unit variable costa – 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
Quantity 1000 1200 1500
per unit total, $ per unit total, $ per unit total, $ Overall,$
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
Profit 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
Quantity 1000 0 1500
per unit total,$ per unit total, $ per unit Total,$ Overall,$
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
Profit -5 -5 310 0 0 -4 -6 200 -11 510
Contribution 14 14 000 0 0 10 14 490 28 490
Increases in activity level (unlimited)
A B C
Quantity 2500 1200 1500
per unitIncremental Total, $ per unit Total, $ per unit
Total, $
Overall, $
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
Quantity 1000 1200 1500
per unit Total, $ per unit Total, $ per unit Total, $ Overall
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
Order 2 3 1 max hours
Demand in units (general) 6000 7000 6000 19000
Total labour demand (due to contr per lim.factor) 7000 0 12000
PricingPrice of the competitor is 250 $ per unit/What should be our price?choice 1 Higher better quality higher Costschoice 2 Lower price
1 way 2 way
Quantity sold 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)
Quantity 1000 1000
per unit Total, $ per unit Total, $
Price(sales) x x 150 150000
VC 50 50000 x x
FC (allocated) 100000 x x
Costs 50 150000 150 150000
Profit 0 0 0 0
PQ=FC+VC*Q
Quantity 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 20000
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) costingDirect costing
are regarded as period costs(writtenas a lump sum to the profit and lossaccount)
are assigned to the products
are period costs
are added to the variablemanufacturing cost of sales todetermine 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
Additional slides
• Direct Costing Solves the Forecasting Problem in Pricing
• Direct Costing focuses on Variable and Incremental Costs
• With Direct Costing you will be able to calculate:
▫ Floor Price
▫ Out of Pocket Price
▫ Break Even Price
▫ Target Profit Price
▫ Most profitable sales mix
▫ Profitable Sales Strategies
• Direct Costing works well for Service Companies and Mfg Companies
Additional slides
Sector
Mgt Entity
Corp Parent
Bus. Unit
Factory
Part/Article Number
Cost Pool Cos
t D
rive
r
OperationsMarketing
Sector
Mgt Entity
Corp Parent
Bus Unit
Market
Segment
Mfg CellProd LineDat
a S
tan
dar
ds
P&L
Direct Costing Model
Driving Pools to the Article Number
•Mfg Cell Labor•Fringe Benefits•Mfg Salaries•Building Insurance•Quality Labor•Dept Shop
Supplies• Repair &
Maintenance by Dept
Cost Pools Cost Drivers
• Quantity Produced• Kilo’s Produced• Kilowatt Hours• Machine Hours• Labor Hours• Square Feet• Takt Time• Linear Meters
Additional slides
Traditional Standard Costing @ Item # Level•Used for Inventory Valuation
Materials & OSS
Labor
Mfg Overhead
General & Administrative
•Material is approximated/driven by the Bill-of-material
•Standard Hours are an accurate reflection of labor content
•Overheads are traced to Item Numbers by the Labor Content
•G&A can be traced to Item numbers by the Labor Content
•Inventory Valuation objectives are compatible with pricing objectives.
Bill of Material
Std Hrs x Std Rate
% of Labor
% of Labor
Direct Costing @ Mfg Cell & Product Line Level•Used for Pricing, Order Selection, Make vs Buy, Market Analysis
Materials & OSS
Labor
Driven Direct Costs
Driven Fixed, Semi-Var
•Material is approximated/driven by the Bill-of-material to the Article Number
•Labor is pooled at the Mfg Cell Level
•Direct Overheads are traced to the Pool closest to the Article Number.
•Fixed Costs are traced to the Pool closest to the Article Number
•Direct Costs are built up to the Product Line Level and used in Estimating
Bill of Material
Actual Lbr in Cell
Overheads to Pools
Cost Driver Data Collection
What we gain from Direct Costing
• Target Price• BE Price• Floor Price• Out-of-Pocket Point• Consistent Business
Analysis Tool• Mix Decisions
become easier• Facts not Fiction• Better Knowledge of
our Strengths & Weaknesses
• Reconciliation of Cost
Upside Downside
• We must continue to maintain Std Cost for Inventory Valuation
• Drivers are expensive to collect
• Requires better training & education in pricing
• Requires IT systems to work.
Additional slides
Additional slides
•What is Contribution?
Direct Costs
Unknowable Variable Costs
Fixed Costs
ProfitC
ontr
ibut
ion
Floor Price (OOP)
BE Price
Target Price
Strategy of Price
Direct Costing is only one source of Price Strategy information.
Other Strategy Information Points:
1. Customer Value Chain Analsyis
2. Market Floor Price
3. Market Ceiling Price
4. Government Intervention
5. Competitor Position
Strategy of Price
Low HiCompetitive Intensity
Str
ateg
ic P
ricin
g F
reed
om
Low
Hi
Specialty Products
Commodity Products
• Price Point vs. Economic Value or Alternate Products
• Where will price move given demand, cost, & capacity
Key Strategies & Blind SpotsValue Positioning vs. Competition Too little emphasis on exploiting
product/service attribute advantages vs. competition
Failure to identify product-specific or customer-specific costs (Cost to Serve)
Low price on System, High price on replacement parts & service (or vice versa)
Focus on Profit %’s vs. Profit $…Specialty vs. Commodity Product
Underestimation of competitor capabilities and desires
Lack of understanding of current point on the demand curve
Understanding of Costs
Product Positioning & Cannibalization due to price
Risks of a destructive competitor response to a new price initiative
Penetration Pricing vs. Skim Pricing
Balance System Profits vs. Component/Svc Profits
Strategy
What does the customer value?
Customer Values Us ThemProduct Downtime Reduction Good Poor Material Savings Excellent Good Labor Savings Good Good Low Failure Potential Poor GoodInventory Immediate Parts Availability Excellent Poor Time saved in sourcing Good GoodSales Service Ready access to source Good Excellent Ability to ID parts for task Good Excellent Regular Bin Maintenance Good Poor Minimized Paperwork Excellent Poor Relationship w/Sales Staff Good Good Ability to solve order errors Poor Poor Ability to solve product problems Excellent GoodCustomer Service Regular Deliveries Good Good On Time Deliveries Excellent Poor No Credit Delays Poor Excellent Billing Convenience Poor Excellent Packaging fits inventory system Good Excellent Emergency Delvy Capability Excellent Poor
Competitive Advantage
Direct Costing Implementation
Educate Leadership
Create Sector Deployment Teams
Identify IT System Deficiencies
Establish Centralized Reporting System
Develop Sales Mgt Scorecard
Thank you for attention!!