Direct Costing
In direct costing method by allocation of appropriate portion of direct cost the product’s cost or operation is determined. Fixed costs are treated as period costs in direct costing. Direct costing is also called as variable costing or contribution costing. It directly associates with the changes in production volumes.
Uses of direct costing are:
- Equipment purchases: acquiring of efficient processing equipment will result in lowering of direct cost of the product. If machines take over those tasks which were performed by employees previously then direct labor cost will be reduced and thus direct costs will also be lowered.
- Price setting: direct costing will help in revealing the lowest price of the product that a customer wants. This can be done by covering the charged price to the customer.
- Profitability analysis: Determination of the most profitable customer can be done by this. This can be done by the subtraction of direct costs from the prices that are paid and this gives the maximum amount that is contributed towards the coverage of company’s profit and overhead costs.
- Budgeting: Concept of direct costing can be included in budgeting system. Budgeted direct costs are changed in order to match the achieved actual sales volume. A closer approach between the budgeted and real cost of the goods sold can be achieved by this. This is because the budget is now fixed with experienced actual volume level.
Problems with direct costing:
In many situations direct costing should not be used. Its biggest problem is that all the indirect costs are excluded from it.It is also not appropriate when while dealing with pricing decisions and long term costing. Results which are yielded by direct costings do not achieve long term profitability.
- Long term pricing: it does not include overhead costs due to which company can suffer loss in future.
- Capacity assumptions: steady level of unit costs is assumed in direct costing
- Step costs: all those types of costs that are within direct costing definitions will increase.
Inventory valuation: inventory valuation cannot be done by direct costing since GAAP does not allow this. This is because in this method all costs except direct costs are charged to current period.
Written by: Matt
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Tagged as assumptions, budget, budgeting system, customer profitability analysis, decisions, direct costing, equipment purchases, indirect costs, overhead costs, period costs, processing equipment, production volumes, profitable customer, sales volume, subtraction, term profitability, variable costing, volume level + Categorized as Business, Economy articles, Finance