1. Direct Costing Todd Kleibor, CPA, CMA Rick Magnuson Smith & Gesteland, LLP

2. Todd Kleibor, CPA, CMA - Manufacturing/Supply Chain Manager Todd is a manager in the Assurance Department. His experience has focused on performing audits, reviews, and compilations for manufacturers, distributors, and service organizations. As a co-leader of the manufacturing and distribution niche, Todd focuses his continuing education and client work on issues facing manufacturers. In addition to the traditional assurance services, Todd is skilled in designing, evaluating and improving inventory costing policies and procedures. He also has experience in reviewing and enhancing internal controls and operating efficiencies for his clients.

3. Rick Magnuson, Strategic Advisor – Profit Enhancement Group of Smith & Gesteland Rick is a Strategic Advisor in the Profit Enhancement Solutions group. Rick worked for 35 years with Illinois Tool Works (ITW)Illinois Tool Works (ITW). He worked in manufacturing, finance, sales and operations in many different ITW companies. He has been instrumental in improving profitability and creating growth in over 130 individual business units with a wide range of products including electronics, food equipment, and manufacture of switches and screws. Rick directed businesses in many industries through a variety of sales channels. Most recently, Rick was the group controller of the ITW Food Equipment Group where he worked with brands including Hobart and Vulcan. He has held management positions from Vice President to General Manager to International Controller for ITW companies such as Pancon, Shakeproof, ITW Switches and ITW Cortron.

4. Learning Objectives Understand the current state of costing

5. Learning Objectives Provide an overview of direct costing

6. Learning Objectives Understand the benefits of direct costing

7. Learning Objectives Direct costing in application – case studies

8. Learning Objectives Keys to successfully implementing direct costing

9. The Current State Traditional Costing Systems –Compliance driven (GAAP, taxes, etc.) –Not operationally effective –Often complex –Rely heavily on estimates –Often driven by labor hours

10. Unintended Consequences Misrepresent our cost structure –The highest volume products take a disproportionately higher share of the cost base –Over cost the high volume product and under cost the low volume product –Make pricing decision based upon our ‘costs’ (cost + markup)

11. What is Direct Costing? Direct Costing –Accounting method used for valuing inventory and calculating income –Requires separating manufacturing costs between those resulting from volume (variable), and those resulting from the passage of time (fixed) –Under direct costing, fixed costs are not allocated to inventory, but rather, expensed on the income statement when incurred

12. What is Direct Costing? (continued) –Variable costs Direct materials Direct labor Fringe benefits Purchase price variance Scrap Freight Inventory adjustments Supplies Packaging Etc.

13. What is Direct Costing? (continued) Fixed costs – sunk, incurred regardless of manufacturing activity –Manufacturing salary labor –Manufacturing indirect labor –Depreciation –Rent –Insurance –Taxes –Utilities This analysis varies by company and industry

14. Direct Costing Benefits Simpler product costing Overhead costs are more easily tracked and managed Easier to analyze and plan No Income Statement benefits from building inventory No Income Statement reversals from reducing inventory

15. Direct Costing Benefits (continued) Direct costs –Controlled at the operating level –Operations monitors and manage these costs Indirect costs –Controlled at the management level –Fixed in nature, have little variability Pricing decisions become easier –Product costs are variable –Anything greater than variable costs contributes to the fixed cost base

16. Direct Costing - Case Study - One Pricing Decisions – Full Absorption Costing –Assume the facility has capacity –A customer offers to buy widgets at $18.00/ea –Full absorption product cost is $20.00/ea –What decision will be made by the sales manager?

17. Direct Costing - Case Study - One Pricing Decisions – Direct Costing –The product cost is modified to exclude fixed costs of $7.00/ea –Assume the facility has capacity –A customer offers to buy widgets at $18.00/ea –Direct costing product cost is $13.00/ea –What decision will be made by the sales manager?

18. Direct Costing - Case Study - Two ProductSales Price Direct Cost Allocated OH Total Cost Profit (Loss) Contribution Product A$15.00$10.00$4.00$14.00$1.00$5.00 Product B$10.00$7.00$2.80$9.80$0.20$3.00 Product C$40.00$36.00$14.00$50.00$(10.00)$4.00 Which of these products should you concentrate your marketing efforts on? Some would say Product C as it maximizes sales dollars. Some would say Product A as it maximizes contribution/unit. Since producing Product C results in a loss, it’s a mistake to produce them isn’t it?

19. Direct Costing - Case Study - Three Income Statement impact – Full Absorption JanuaryFebruary Sales$100,000$125,000 Raw Mat$25,000$31,250 Var. Labor$15,000$18,750 Var. OH$20,000$25,000 Fixed OH$20,000$25,000 $80,000$100,000 Fixed OH$20,000 FOH – Applied ($25,000)($20,000) ($5,000)$-0- Gross Profit$25,000 Inventory$5,000-0- Income Statement impact – Direct Costing JanuaryFebruary Sales$100,000$125,000 Raw Mat$25,000$31,250 Var. Labor$15,000$18,750 Var. OH$20,000$25,000 Total Var.$60,000$75,000 CM$40,000$50,000 Fixed OH$20,000 Gross Profit$20,000$30,000 Inventory-0-

20. Direct Costing - Case Study Your Largest Customer Wants a 10% Price Reduction Income Statement impact – Full Absorption JanuaryFebruary Sales$100,000$125,000 Raw Mat$25,000$31,250 Var. Labor$15,000$18,750 Var. OH$20,000$25,000 Fixed OH$20,000$25,000 $80,000$100,000 Fixed OH$20,000 FOH – Applied ($25,000)($20,000) ($5,000)$-0- Gross Profit$25,000 Inventory$5,000-0- Income Statement impact – Direct Costing JanuaryFebruary Sales$100,000$125,000 Raw Mat$25,000$31,250 Var. Labor$15,000$18,750 Var. OH$20,000$25,000 Total Var.$60,000$75,000 CM$40,000$50,000 Fixed OH$20,000 Gross Profit$20,000$30,000 Inventory-0-

21. Direct Costing – Case Study – Four Contrasting Direct Costing & Absorption Costing Assumptions: Selling Price = $37,500 Manufacturing Cost –Direct = $15,000 per machine –Period = $50,000 per month Selling, General & Administrative = $20,000 per month Normal Production Volume – 5 machines per month JanuaryFebruaryMarch Machines produced453 Machines sold444 Inventory, end of month -1-

22. Direct Costing – Case Study – Four Contrasting Direct Costing & Absorption Costing Absorption CostingDirect Costing JanFebMarchJanFebMarch Sales$150 COGS100 60 Unabsorbed OH10-20--- Gross Profit40503090 Manufacturing (period costs) ---50 SGA20 Net Profit20301020 Inventory, End of Period -25--15-

23. Direct Costing – Warning!! GAAP –Requires that total charges, direct, or indirectly incurred to bring inventories to their existing condition and location are capitalized Direct Costing –Management tool –Needs adjusting to bring financial statements to GAAP basis

24. Keys to a Successful Implementation Identify and agree on fixed and controllable costs Prepare a direct cost format income statement Set up initial conversion journal entries Quarterly inventory ‘step up’ –Entries –Methodology Recast prior periods Run parallel for 3-6 months

25. Direct Cost – Income Statement Format Revenues Variable Expenses Direct Material Direct Labor Fringe Benefits Purchase Price Variance Scrap Freight Inventory Adjustments Supplies Packaging Expense Total Variable Expenses Contribution Margin % Period Costs Manufacturing Salary Labor Manufacturing Indirect Labor Fringe Benefits Depreciation Rent Insurance Taxes Utilities Other Total Period Costs % Gross Profit % SGA % Operating Income %

26. Direct Costing Questions?

27. Direct Costing – Contact Info www.sgcpa.com Todd Kleibor Todd.Kleibor@sgcpa.com (608)836-7500 Rick Magnuson Rick.Magnuson@sgcpa.com (608)836-7500 Please take a moment to complete a short survey