Fundamentals of Direct Costing

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Direct Costing is primarily used within an organization as an internal source of information for planning and control. The purpose of direct costing is to facilitate the distribution of costs among products, line of business and profit centers. The scope of direct costing can be better understood with the help of the concepts given below:

Direct Costs: These are costs incurred which are traceable to a specific product or line of business. Example: Advertisement and Publicity Expenses, Procurement Expenses, Conveyance Expenses, Travelling Expenses and fixed expenses of employees whose salaries are  charged direct.

Indirect Costs: These costs cannot be specifically assigned to a product or line of business. Example: Office Rent, Property Taxes, General Management Salaries.

Direct Costs can be Variable or Fixed Costs.                                                                           

Variable Costs: These costs change as the level of activity changes.

Fixed Costs: These costs are constant and do not change with changes in the level of activity.

Marginal Income:  This refers to the (Revenue – Direct Variable Costs)

Contribution to Indirect Cost and Profit: This refers to the (Marginal Income – Direct Fixed Cost)

Net gain before tax: This refers to the (Revenue – Direct Variable Cost – Direct Fixed Cost – Indirect Costs)

Benefits offered by Direct Costing

The Direct Costing format provides information about each product lines contribution to overheads before allocation of indirect expenses. Direct Costing allows the use of several techniques to enhance cost control and to increase the effectiveness of product planning and project monitoring.

Profit Planning:  ‘Marginal Income’ calculates the actual economic contribution of each line of business or product line. It allows the calculation of ‘contribution to indirect cost and profits’. This allows the management to make timely decisions concerning product costing and product mix.

Flexible Budgeting: Fixed costs and variable costs for a responsibility area or cost center are identified. While fixed cost is a flat dollar amount, variable costs are budgeted based on the expected or assumed activity level and the standard unit cost. This is how flexible budgeting is done and the manager is responsible for all cost over-runs for reasons like volume fluctuations due to inefficiencies.

Project Monitoring: Corrective action and reduction of losses against plans can be effected. This is made possible by the financial reporting of actual results on the same basis as planned and calculated by direct costing.

New Product Analysis: Marginal Income for the new product can be analyzed. This is significant for management to understand the expected contribution of a proposed new product to overheads and profits.

A skilled professional can mathematically distinguish variable and fixed costs within a relevant range of activity. There are various statistical method that can be used like Regression analysis, high and low points, scatter graphs and linear programming. Amongst these, linear programming is perhaps the most useful method in arriving at the variable and fixed portions of the cost. Each Company will have its own management information needs. The realization of these needs depends on the affordability of a simple or more advanced costing system.