What are the enternal uses of direct costing?

Answer 1

A direct cost is a cost that is directly associated with changes in production volume. This usually restricts the definition of direct costs to direct materials and direct labor (and a strong case can be made for not using direct labor, since this costs tends to be present even when production volumes vary). For example, the materials used to create a product are a direct cost, whereas the machine used to convert the materials into a finished product is not a direct cost, because it is still going to be sitting on the factory floor, irrespective of any changes in production volume. By focusing solely on the direct cost of a product or activity, a cost accountant can provide valuable information to management regarding prospective changes in costs that will arise as a result of some management action. For example, if a change to a more efficient type of processing equipment is contemplated, then the direct cost of a product may be lowered if this will result in less material usage. This may also result in less direct labor cost if the machine takes over some tasks previously performed by employees - this will cut direct costs, but may increase overhead costs if the cost of the machine is higher than that of the machine that it is replacing. Yet another example is when a customer wants the lowest possible price for a product, and the company has some free capacity available for producing what the customer needs; the use of direct costing will reveal the lowest possible cost that must be covered by the price charged to the customer in order to break even. Direct costing can also be used to determine which customers are the most profitable, by subtracting the direct cost of their purchases from the prices paid, which yields the amount they are contributing toward the company's coverage of overhead costs and profit. Another very good use for direct costing is to include the concept in the budgeting system, where it is used to change budgeted variable costs to match the actual sales volumes achieved; this approach achieves a much closer match between the budgeted and actual cost of goods sold, because the budget now flexes with the actual volume level experienced. For all of these reasons, direct costing is a highly recommended costing system. However, there are a number of situations in which direct costing should not be used, and in which it will yield incorrect information. Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today's companies. This is a real problem when dealing with long-term costing and pricing decisions, since direct costing will likely yield results that do not achieve long-term profitability. For example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs, but which is lower than the additional overhead costs that are associated with the product line. If the company continues to use the $10.00 price for all product sales for well into the future, then the company will experience losses because overhead costs are not being covered by the price. The best way to address this problem is to build strict boundaries around the circumstances where incremental prices derived from a direct costing system are used. Another problem with direct costing is that it assumes a steady level of unit costs for the incremental costing and pricing decisions for which it is most often used. For example, a company receives an offer from a customer to buy 5,000 units of Product ABC at a fixed price. The cost accounting staff may determine that the proposed price will indeed yield a profit, based on the direct cost per unit, and so recommends that the deal be approved. However, because the staff has only focused on direct costs, it has missed the fact that the company is operating at near full-capacity levels, and that to process the entire 5,000-unit order will require the addition of some costly machinery, the acquisition of which will make the proposed deal a very expensive one indeed. To avoid this problem, anyone using a direct costing system must have access to company capacity information, and should coordinate with the production scheduling staff to ensure that capacity levels will permit their incremental pricing and costing scenarios to be achieved. A subtle issue that many users of direct costing systems miss is that the types of costs that fall within the direct costing definition will increase as the volume of units in a direct costing decision go up. For example, the only direct cost involved with a single unit of production is the direct materials used to build it, whereas a larger production volume will likely involve some change in the related number of manufacturing employees needed on the production line; these are well-accepted concepts. However cost Accountants frequently forget that additional direct costs will be included when the production volume rises to even higher levels. For example, if the direct costing decision involves an entire production line, then all of the equipment and supervisory costs that are tied to that production line are now also influenced by the decision to produce or not produce, and so should be included in the direct costing system. At an even larger level, the decision to use the production of an entire facility should include every cost needed to run that facility, which may included utilities, rent, and insurance - costs that are not normally included in smaller-volume production decisions. Consequently, direct costing analysis must be conducted within narrowly defined volume ranges, with careful attention to what costs are likely to vary with the volumes that are under review. Direct costing cannot be used for inventory valuation, because it is disallowed by GAAP. The reason for this is that, under a direct costing system, all costs besides direct costs are charged to the current period. There is no provision for capitalizing overhead costs and associating them with inventory that will be sold off in future periods. This results in an imbalance between the reported level of profitability in each period and the amount of production that occurred. For example, a manufacturer of Christmas ornaments with a direct costing system may sell all of its output in one month of the year, but be forced to recognize all of its non-direct production costs in every month of the year, which will result in reported losses for eleven months of the year. Under GAAP, these non-direct costs would be capitalized into inventory and recognized only when the inventory is sold, thereby more closely matching reported revenues and expenses. Given the wide disparity between the reported results, it is no surprise that GAAP bans the use of direct costing for inventory valuation.