Transcript Using direct (marginal) costing for decision making

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
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
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•
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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
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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)
Quantity
A
B
C
1000
1200
1500
per unit
total, $
per unit
total, $
per unit
total, $
Overall,$
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
14
14 000
10
12 000
10
14 490
40 490
Contribution
Quantity
A
B
C
1000
0
1500
per unit
total,$
per unit
total, $
per unit
Total,$
Overall,$
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
Increases in activity level (unlimited)
A
B
C
1200
1500
Quantity
2500
per unit
Incre
mental
Total, $
per unit
Total, $
per unit
Total, $
Overall,
$
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
23 382
-3
-3 934
1
2 042
11 490
35 000
10
12 000
10
14 490
61 490
Contribution
14
+9150
Increases in activity level (limited)
Quantity
A
B
C
1000
1200
1500
per unit
Total, $
per unit
Total, $
per unit
Total, $
Overall
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
14
14 000
10
12 000
10
14 490
40 490
Contribution
Number of labour hours used
3
3
2
4,67
3,33
4,83
2
3
1
Demand in units (general)
6000
7000
6000
Total labour demand (due to contr
per lim.factor)
7000
0
12000
Contribution per hour
Order
max hours
19000
Pricing
Price of the competitor is 250 $ per unit/
What should be our price?
choice 1
Higher
better quality
higher Costs
choice 2
Lower price
Quantity sold
per unit
1 way
2 way
10 000
12 000
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
To produce or to buy
Produce
Buy (unlimited)
1000
1000
Quantity
per unit
Price(sales)
VC
Total, $
per unit
Total, $
x
x
50
50000
x
x
100000
x
x
FC (allocated)
150
150000
Costs
50
150000
150
150000
Profit
0
0
0
0
PQ=FC+VC*Q
Quantity
Produce
Buy (unlimited)
1200
1200
per unit
Price(sales)
VC
Total, $
Profit
Total, $
150
180000
50
60000
x
x
100000
x
x
FC (allocated)
Costs
per unit
50
160000
20000
150
150
180000
180000
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
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
are assigned to the products
Variable manufacturing costs
Non-manufacturing overheads
are period costs
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
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
Direct Costing Model
Marketing
Operations
Corp Parent
Corp Parent
Sector
Sector
Mgt Entity
Mgt Entity
Bus Unit
Bus. Unit
Market
Factory
Segment
Cost Pool
Prod Line
Mfg Cell
Part/Article Number
P&L
Additional slides
Driving Pools to the Article Number
Cost Pools
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Mfg Cell Labor
Fringe Benefits
Mfg Salaries
Building Insurance
Quality Labor
Dept Shop Supplies
Repair & Maintenance
by Dept
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Cost Drivers
Quantity Produced
Kilo’s Produced
Kilowatt Hours
Machine Hours
Labor Hours
Square Feet
Takt Time
Linear Meters
Traditional Standard Costing @ 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
Bill of Material
Std Hrs x Std Rate
•G&A can be traced to
Item numbers by the
Labor Content
% of Labor
•Inventory Valuation
objectives are
compatible with pricing
objectives.
% of Labor
Direct Costing @ Mfg Cell & Product Line Level
•Used for Pricing, Order Selection, Make vs Buy, Market Analysis
Materials & OSS
•Material is
approximated/driven by
the Bill-of-material to
the Article Number
Bill of Material
•Labor is pooled at the
Mfg Cell Level
Labor
Driven Direct Costs
Driven Fixed, Semi-Var
•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
Actual Lbr in Cell
Overheads to Pools
Cost Driver Data
Collection
Additional slides
What we gain from Direct Costing
Upside
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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
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?
Target Price
BE Price
Floor Price (OOP)
Contribution
Profit
Fixed Costs
Unknowable Variable Costs
Direct Costs
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
Strategic Pricing Freedom
Hi
•
Price Point vs.
Economic Value
or Alternate
Products
Specialty Products
•
Where will price
move given
demand, cost, &
capacity
Low
Commodity Products
Low
Hi
Competitive Intensity
Key Strategies & Blind Spots
Value Positioning vs. Competition
Too little emphasis on exploiting
product/service attribute advantages vs.
competition
Understanding of Costs
Failure to identify product-specific or
customer-specific costs (Cost to Serve)
Balance System Profits vs.
Component/Svc Profits
Low price on System, High price on
replacement parts & service (or vice versa)
Product Positioning &
Cannibalization due to price
Focus on Profit %’s vs. Profit $…Specialty
vs. Commodity Product
Risks of a destructive competitor
response to a new price initiative
Underestimation of competitor capabilities
and desires
Penetration Pricing vs. Skim
Pricing
Lack of understanding of current point on
the demand curve
Strategy
What does the customer value?
Customer Values
Product
Downtime Reduction
Material Savings
Labor Savings
Low Failure Potential
Inventory
Immediate Parts Availability
Time saved in sourcing
Sales Service
Ready access to source
Ability to ID parts for task
Regular Bin Maintenance
Minimized Paperwork
Relationship w/Sales Staff
Ability to solve order errors
Ability to solve product problems
Customer Service
Regular Deliveries
On Time Deliveries
No Credit Delays
Billing Convenience
Packaging fits inventory system
Emergency Delvy Capability
Competitive Advantage
Us
Them
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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!!