Using direct (marginal) costing for decision making group: Sepkulova Dina Tarakanov Dmitry Shlyaga Nina Kozhevnikova Nadezhda

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.

The principles of marginal costing 1.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

Features of Marginal costing 1.Cost Classification T he 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

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

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

CVP diagram

A mathematical approach to CVP analysis NP=Px-(a+bx), NP – net profit x – units sold P – selling price b – unit variable cost a – total fixed costs

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

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

Range of goods planning (1) ABC Quantity per unittotal, $per unittotal, $per unittotal, $Overall,$ Price(sales) VC FC (allocated) Costs Profit Contribution ABC Quantity per unittotal,$per unittotal, $per unitTotal,$Overall,$ Price(sales) VC FC (allocated) Costs Profit Contribution

Increases in activity level (unlimited) A BC Quantity per unit Incre mentalTotal, $per unitTotal, $per unitTotal, $ Overall, $ Price(sales) VC FC (allocated) Costs Profit Contribution

Increases in activity level (limited) ABC Quantity per unitTotal, $per unitTotal, $per unitTotal, $ Overall Price(sales) VC FC (allocated) Costs Profit Contribution Number of labour hours used3 3 2 Contribution per hour4,67 3,33 4,83 Order2 3 1 max hours Demand in units (general) Total labour demand (due to contr per lim.factor)

Pricing Price of the competitor is 250 $ per unit/ What should be our price? choice 1Higher better quality higher Costs choice 2Lower price 1 way2 way Quantity sold per unitTotal, $per unitTotal,$ Price(sales) VC FC (allocated) Costs Profit Contribution BEP Capacity

To produce or to buy ProduceBuy (unlimited) Quantity 1000 per unitTotal, $per unitTotal, $ Price(sales)xx VC xx FC (allocated) xx Costs Profit0000 PQ=FC+VC*Q Quantity ProduceBuy (unlimited) 1200 per unitTotal, $per unitTotal, $ Price(sales) VC xx FC (allocated) xx Costs Profit20000

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

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.

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

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

Direct vs. Absorption (full) costing Direct costing Profit is a function of sales Are recommended where indirect costs are a low proportion of an organization’s 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

Additional slides Direct Costing Solves the Forecasting Problem in Pricing Direct Costing focuses on Variable and Incremental Costs With Direct Costing you will be able to calculate: ▫ Floor Price ▫ Out of Pocket Price ▫ Break Even Price ▫ Target Profit Price ▫ Most profitable sales mix ▫ Profitable Sales Strategies Direct Costing works well for Service Companies and Mfg Companies

Additional slides Sector Mgt Entity Corp Parent Bus. Unit Factory Part/Article Number Cost Pool Cost Driver OperationsMarketing Sector Mgt Entity Corp Parent Bus Unit Market Segment Mfg CellProd Line Data Standards P&L Direct Costing Model

Driving Pools to the Article Number Mfg Cell Labor Fringe Benefits Mfg Salaries Building Insurance Quality Labor Dept Shop Supplies Repair & Maintenance by Dept Cost PoolsCost Drivers Quantity Produced Kilo’s Produced Kilowatt Hours Machine Hours Labor Hours Square Feet Takt Time Linear Meters Additional slides

Traditional Standard Item # Level Used for Inventory Valuation Materials & OSS Labor Mfg Overhead General & Administrative Material is approximated/driven by the Bill-of-material Standard Hours are an accurate reflection of labor content Overheads are traced to Item Numbers by the Labor Content G&A can be traced to Item numbers by the Labor Content Inventory Valuation objectives are compatible with pricing objectives. Bill of Material Std Hrs x Std Rate % of Labor

Direct Mfg Cell & Product Line Level Used for Pricing, Order Selection, Make vs Buy, Market Analysis Materials & OSS Labor Driven Direct Costs Driven Fixed, Semi-Var Material is approximated/driven by the Bill-of-material to the Article Number Labor is pooled at the Mfg Cell Level Direct Overheads are traced to the Pool closest to the Article Number. Fixed Costs are traced to the Pool closest to the Article Number Direct Costs are built up to the Product Line Level and used in Estimating Bill of Material Actual Lbr in Cell Overheads to Pools Cost Driver Data Collection

What we gain from Direct Costing Target Price BE Price Floor Price Out-of-Pocket Point Consistent Business Analysis Tool Mix Decisions become easier Facts not Fiction Better Knowledge of our Strengths & Weaknesses Reconciliation of Cost Upside Downside We must continue to maintain Std Cost for Inventory Valuation Drivers are expensive to collect Requires better training & education in pricing Requires IT systems to work. Additional slides

What is Contribution? Direct Costs Unknowable Variable Costs Fixed Costs Profit Contribution Floor Price (OOP) BE Price Target Price

Strategy of Price Direct Costing is only one source of Price Strategy information. Other Strategy Information Points: 1.Customer Value Chain Analsyis 2.Market Floor Price 3.Market Ceiling Price 4.Government Intervention 5.Competitor Position

Strategy of Price LowHi Competitive Intensity Strategic Pricing Freedom Low Hi Specialty Products Commodity Products Price Point vs. Economic Value or Alternate Products Where will price move given demand, cost, & capacity

Key Strategies & Blind Spots Value Positioning vs. CompetitionToo little emphasis on exploiting product/service attribute advantages vs. competition Failure to identify product-specific or customer-specific costs (Cost to Serve) Low price on System, High price on replacement parts & service (or vice versa) Focus on Profit %’s vs. Profit $…Specialty vs. Commodity Product Underestimation of competitor capabilities and desires Lack of understanding of current point on the demand curve Understanding of Costs Product Positioning & Cannibalization due to price Risks of a destructive competitor response to a new price initiative Penetration Pricing vs. Skim Pricing Balance System Profits vs. Component/Svc Profits

Strategy What does the customer value?

Direct Costing Implementation Educate Leadership Create Sector Deployment Teams Identify IT System Deficiencies Establish Centralized Reporting System Develop Sales Mgt Scorecard

Thank you for attention!!