Direct costing is a specialized form of cost analysis that only uses variable costs to make decisions. It does not consider fixed costs, which are assumed to be associated with the time periods in which they were incurred. The direct costing concept is extremely useful for short-term decisions, but can lead to harmful results if used for long-term decision making, since it does not include all costs that may apply to a longer-term decision. In brief, direct costing is the analysis of incremental costs. Direct costs are most easily illustrated through examples, such as:
- The costs actually consumed when you manufacture a product
- The incremental increase in costs when you ramp up production
- The costs that disappear when you shut down a production line
- The costs that disappear when you shut down an entire subsidiary
The examples show that direct costs can vary based upon the level of analysis. For example, if you are reviewing the direct cost of a single product, the only direct cost may be the materials used in its construction. However, if you are contemplating shutting down an entire company, the direct costs are all costs incurred by that company – including all of its production and administrative costs. The main point to remember is that a direct cost is any cost that changes as the result of either a decision or a change in volume.
Direct Costing Uses
Direct costing is of great use as an analysis tool. The following decisions all involve the use of direct costs as inputs to decision models. They contain no allocations of overhead, which are not only irrelevant for many short-term decisions, but which can be difficult to explain to someone not trained in accounting.
- Automation investments. A common scenario is for a company to invest in automated production equipment in order to reduce the amount it pays to its direct labor staff. Under direct costing, the key information to collect is the incremental labor cost of any employees who will be terminated, as well as the new period costs to be incurred as part of the equipment purchase, such as the depreciation on the equipment and maintenance costs.
- Cost reporting. Direct costing is very useful for controlling variable costs, because you can create a variance analysis report that compares the actual variable cost to what the variable cost per unit should have been. Fixed costs are not included in this analysis, since they are associated with the period in which they are incurred, and so are not direct costs.
- Customer profitability. Some customers require a great deal of support, but also place such large orders that a company still earns a considerable profit from the relationship. If there are such resource-intensive situations, it makes sense to occasionally calculate how much money the company really earns from each customer. This analysis may reveal that the company would be better off eliminating some of its customers, even if this results in a noticeable revenue
- Internal inventory reporting. Generally accepted accounting principles and international financial reporting standards require that a company allocate indirect costs to its inventory asset for external reporting purposes. Overhead allocation can require a prolonged amount of time to complete, so it is relatively common for company controllers to avoid updating the overhead allocation during reporting periods when there will be no external reporting. Instead, they rely mostly on direct cost updates, and either avoid all changes to the overhead allocation, or make an approximate guess at the correct overhead allocation based on a proportion of direct costs, and make a more accurate adjustment when a reporting period arrives for which the company must report financial statements to outside parties.
- Profit-volume relationship. Direct costing is useful for plotting changes in profit levels as sales volumes change. It is relatively simple to create a direct costing table that points out the volume levels at which additional direct costs will be incurred, so that management can estimate the amount of profit at different levels of corporate activity.
- Direct costing is useful for deciding whether to manufacture an item in-house or maintain a capability in-house, or whether to outsource it. If the decision involves manufacturing in-house or elsewhere, it is crucial to determine how many staff and which machines will actually be eliminated; in many cases, these resources are simply shifted elsewhere within the company, so there is no net profit improvement by shifting production to a supplier.
Direct Costing Problems
Direct costing is an analysis tool, but it is only usable for certain types of analysis. In some situations, it can provide incorrect results. This section describes the key issues with direct costing that you should be aware of. They are:
- External reporting. Direct costing is prohibited for the reporting of inventory costs under both generally accepted accounting principles and international financial reporting standards. This means that you cannot report the cost of inventory as though it only includes direct costs; you must also include a proper allocation of indirect costs. If you used direct costing for external reporting, then fewer costs would be included in the inventory asset on the balance sheet, resulting in more costs being charged to expense in the current period.
- Increasing costs. Direct costing is sometimes targeted at whether to increase production by a specific amount in order to accept an additional customer order. For the purposes of this specific decision, the analyst usually assumes that the direct cost of the decision will be the same as the historical cost. However, the cost may actually increase. For example, if a machine is already running at 80% of capacity and a proposed decision will increase its use to 90%, this incremental difference may very well result in a disproportionate increase in the maintenance cost of the machine. Thus, be aware that a specific direct costing scenario may contain costs that are only relevant within a narrow range; outside of that range, costs may be substantially different.
- Indirect costs. Direct costing does not account for indirect costs, because it is designed for short-term decisions where indirect costs are not expected to change. However, all costs change over the long term, which means that a decision that can impact a company over a long period of time should address long-term changes in indirect costs. Consequently, if a company uses an ongoing series of direct cost analyses to drive its pricing decisions, it may end up with an overall pricing structure that is too low to pay for its overhead costs.
- Relevant range. A direct costing analysis is usually only valid within the constraints of the current capacity level. It requires a more sophisticated form of direct costing analysis to account for changes in costs as sales volumes or production volumes increase.
Direct costing is an excellent analysis tool. It is almost always used to create a model to answer a question about what actions management should take. It is not a costing methodology for constructing financial statements – in fact, accounting standards specifically exclude direct costing from financial statement reporting. Thus, it does not fill the role of a standard costing, process costing, or job costing system, which contribute to actual changes in the accounting records. Instead, it is used to extract pertinent information from a variety of sources and aggregate the information to assist management with any number of tactical decisions. It is most useful for short-term decisions, and least useful when a longer-term time frame is involved – especially in situations where a company must generate sufficient margins to pay for a large amount of overhead. Though useful, direct costing information is problematic in situations where incremental costs may change significantly, or where indirect costs may be pertinent to the decision.