Using direct marginal costing for decision making group

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

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

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

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) A B C 1000 1200 1500 per unit Price(sales) VC FC total 35 35 000 21 (allocate d) Costs Contribution VC 40 48 0 0 0 30 36 0 0 0 13 15 9 3 4 B 12 1000 11 618 2 35 14 21 32 618 total 2 382 35 000 14 000 21 000 u n it total A 33 per unit Profit Price(sales) 21 000 per u n it 0 43 per unit 51 9 3 4 total -3 0 -3 9 3 40 10 0 12 0 0 00 total 25 37 5 0 0 120 5 0 0 15 23 0 1 0 80 010 6 1500 per u n 24 it 19 19 310 0 0 12 4 4 8 40 000 35 4 5 8 total C 120 0 1 0 1 25 37 5 0 2 042 0 72 5 0 4900 10 15 14 23 40 91 00 44 0 1 40 4900 6 20 6 9 0 40 0 FC (allocate d)

Increases in activity level (unlimited) A B C 2500 1200 1500 per unit increment 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 35 000 10 12 000 10 14 490 61 490 Contribution 14 total per unit total

Increases in activity level (limited) A B C 1000 1200 1500 per Price(sales) VC FC (allocated) Costs per u n it total 35 35 0 0 0 21 21 0 0 0 12 11 6 1 8 33 32 6 1 8 2 3 u n it total per unit total 40 48 0 0 0 25 37 500 120 500 30 36 0 0 0 15 23 010 80 010 27 31 8 7 1 8 12 448 40 000 57 67 8 7 1 24 35 458 120 010 -19 8

Pricing Price is 250 $ per unit choice 1 better quality (higher price, higher FC) choice 2 lower price 1 2 10 000 12 000 per unit total Price(sales) 300 3 000 200 2 400 000 VC 100 1 000 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 2 000 120 1 440 000 BEP 15 000 20 000 Capacity 25 000

To produce or to buy Produce Buy (unlimited) 1000 per unit Price per unit total 150000 50 VC FC (allocated) total 50000 x x 100000 x x 150000 Costs 50 150000 Profit 100 0 Produce Buy (unlimited) 1200 per unit Price(sales) per unit total 150 180000 50 VC FC (allocated) total 60000 x x 100000 x x 150 180000 Costs 50 160000 150 180000 Profit 100 20000 0 0

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 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 Absorption costing Fixed manufactured overheads are regarded as period costs(written as a lump sum to the profit and loss account) are allocated to the products (included in inventory valuation) are assigned to the products Variable manufacturing costs Non-manufacturing overheads are period costs Fixed manufacturing costs are added to the variable manufacturing cost of sales to determine total manufacturing costs are assigned to the products

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 decisionmaking 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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