Using direct (marginal) costing for decision making

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Using direct (marginal) costing for decision
making

• group Sepkulova Dina
• Tarakanov Dmitry
• Kozhevnikova Nadezhda
• Shlyaga Nina

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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 overhead
• in the cost of a unit of product. The entire
  amount of fixed costs are expenses in the year
  incurred.

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The principles of marginal costing

• 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 item
• 2. 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

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Features of Marginal costing

• 1.Cost Classification
• The marginal costing technique makes a sharp
  distinction between
• variable costs and fixed costs. It is the
  variable cost on the basis of
• which production and sales policies are designed
  by a firm following the
• marginal costing technique
• 2. Stock/Inventory Valuation
• Under 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 Contribution
• Marginal 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

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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

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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

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CVP diagram
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A mathematical approach to CVP analysis

• NPPx-(abx),
• NP net profit
• x units sold
• P selling price
• b unit variable cost
• a total fixed costs

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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

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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

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Range of goods planning (1)
  A A B B C C  
  1000 1000 1200 1200 1500 1500  
  per unit total per unit total per unit total  
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 A B B C C  
  1000 1000 0 0 1500 1500  
  per unit total per unit total per unit total  
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
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Increases in activity level (unlimited)
  A A   B B C C  
  2500 2500   1200 1200 1500 1500  
  per unit increment total per unit total per unit total  
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
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Increases in activity level (limited)
  A A B B C C  
  1000 1000 1200 1200 1500 1500  
  per unit total per unit total per unit total  
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    
Rank 2   3   1   max hours
Demand in units 6000   7000   6000   19000
Total labour demand 7000   0   12000    
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Pricing

• Price is 250 per unit
• choice 1 better quality (higher price,higher FC)
• choice 2 lower price

  1 1 2 2
  10 000 10 000 12 000 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
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To produce or to buy
  Produce Produce Buy (unlimited) Buy (unlimited)
  1000 1000 1000 1000
  per unit total per unit total
Price 150 150000 150 150000
VC 50 50000 x x
FC (allocated)   100000 x x
Costs 50 150000 150 150000
Profit 100 0 0 0

  Produce Produce Buy (unlimited) Buy (unlimited)
  1200 1200 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 100 20000 0 0
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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

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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.

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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

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Direct vs. Absorption (full) costing

• Direct costing
• are regarded as period costs(written
• as a lump sum to the profit and loss
• account)
• are assigned to the products
• are period costs
• are added to the variable
• manufacturing cost of sales to
• determine 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
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Direct vs. Absorption (full) costing

• Direct costing
• Profit is a function of sales
• Are recommended where indirect costs are a low
  proportion of an organizations 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

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Thank you for attention!!
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