The conventional cost accounting systems like job costing, process costing and standard costing are based on the concept of full costing, i.e. all the manufacturing costs were allocated among the units produced either completed or semi processed.
Instead of such absorption of the manufacturing costs, the technique of direct costing considers only those costs which are directly related to the production. Such direct costs vary with the volume of production. Direct costing is the American version. In Britain and other countries, this technique is described as marginal costing. It is also referred as incremental costing or differential costing.
The essential feature of the direct costing is that it divides the total manufacturing costs into two groups: (1) Variable costs or direct costs and (2) Fixed costs.
1) Variable costs are those costs which directly vary with the volume of production. Such costs are direct material, direct labor, electric power, factory supplies etc. As they vary with the production, they are also termed as the product costs. The cost per unit incidence of cost remains unchanged at any level of output.
2) Fixed cost are those costs which remain fixed irrespective of the volume of production. Such costs are factory rent, depreciation, insurance charges, taxes in property, salary of the permanent staff etc. Such costs are committed costs. As they arise simply by effluxion of time, they are treated as period costs.
The cost per unit incidence of fixed cost is inversely proportion to the volume of production.
It should be noted that direct costing is a technique which supplements the other conventional cost accounting systems. Direct costing provides the valuable information for analyzing certain important managerial decisions. The principles of direct costing are applied to the break even analysis and the cost volume profit relationships.
It is true that the profit is a key variable in the business operations however, for the purpose of planning and decision making it is the contribution rather than the profit it is the contribution rather than the profit which serves as a key factor. The contribution is an essential outcome of the direct costing. The contribution (C) is nothing but the difference between the sales (S) and the variable cost (V)
Thus, C = S – V
The contribution can be calculated on the unit basis or on the basis of the total sales revenue. It is termed as contribution, because its positive difference contributes towards the fixed costs. Any surplus remaining the absorption of the fixed cost is the profits. Where the business operations result into negative contribution, it indicates that prompt action is required. Negative contribution arises when the selling price is below the variable cost. Variable cost by its nature is a cost that can be postponed. The negative contribution gives a signal regarding the contribution or shutting done of production operations. The concept of contribution is also very important for the multi plant or multi-product business operations. The contribution of each product or division be ascertained on individual basis and their relative efficiency can be judged. The aggregation of the individual contribution will create a contribution pool which will be utilized to wipe off the fixed costs of the whole organization.
The ABC Ltd is manufacturing only one Standard Product. The cost per unit data of this standard product is as under:
Direct material Rs 12; Direct labor Rs 7; direct expenses Rs 3.
During the year, the company manufactured 1,000 standard products. The entire production was sold at a price of Rs 50 per unit. Here no opening or ending inventories. The fixed overheads of the company for the year were Rs 15,000.
Calculate the amount of the contribution and profits for the year under review.
Sales (1,000 units @ Rs 50) = Rs 50,000
Less: Variable costs:
1) Direct material (1,000 x 12) = 12,000
2) Direct labor (1,000x 7) = 7,000
3) Direct expenses (1,000 x 3) = 3,000 22,000
Total contribution (C=S–V) = 28,000
Less: Total Fixed costs = 13,000
The total profits on the sale of 1,000 units are Rs 15,000. Therefore the profit per unit comes to Rs 15 (Rs 15,000 ÷ 1,000 units) at the sales volume of 1,000 units. Due to the existence of the fixed element in the cost structure, the per unit profit will change along with the change in the volume of production and sales.