Smith & Gesteland direct costing techniques

Direct Costing

Todd Kleibor, CPA, CMARick Magnuson

Smith & Gesteland, LLP

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.  

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).  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.

Learning Objectives

• Understand the current state of costing

Learning Objectives

• Provide an overview of direct costing

Learning Objectives

• Understand the benefits of direct costing

Learning Objectives

• Direct costing in application – case studies

Learning Objectives

• Keys to successfully implementing direct costing

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

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)

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

What is Direct Costing? (continued)

– Variable costs• Direct materials• Direct labor• Fringe benefits• Purchase price variance• Scrap• Freight• Inventory adjustments• Supplies• Packaging• Etc.

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

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

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

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?

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?

Direct Costing - Case Study - TwoProduct Sales

PriceDirect 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?

Direct Costing - Case Study - ThreeIncome Statement impact – Full Absorption

January FebruarySales $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 $20,000

FOH – Applied

($25,000) ($20,000)

($5,000) $-0-

Gross Profit $25,000 $25,000

Inventory $5,000 -0-

Income Statement impact – Direct Costing

January FebruarySales $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 $20,000

Gross Profit $20,000 $30,000

Inventory -0- -0-

Direct Costing - Case StudyYour Largest Customer Wants a 10% Price Reduction

Income Statement impact – Full Absorption

January FebruarySales $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 $20,000

FOH – Applied

($25,000) ($20,000)

($5,000) $-0-

Gross Profit $25,000 $25,000

Inventory $5,000 -0-

Income Statement impact – Direct Costing

January FebruarySales $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 $20,000

Gross Profit $20,000 $30,000

Inventory -0- -0-

Direct Costing – Case Study – FourContrasting 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

January February MarchMachines produced 4 5 3

Machines sold 4 4 4

Inventory, end of month

- 1 -

Direct Costing – Case Study – FourContrasting Direct Costing & Absorption Costing

Absorption Costing Direct CostingJan Feb March Jan Feb March

Sales $150 $150 $150 $150 $150 $150

COGS 100 100 100 60 60 60

Unabsorbed OH 10 - 20 - - -

Gross Profit 40 50 30 90 90 90

Manufacturing (period costs)

- - - 50 50 50

SGA 20 20 20 20 20 20

Net Profit 20 30 10 20 20 20

Inventory, End of Period

- 25 - - 15 -

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

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

Direct Cost – Income Statement FormatRevenues

Variable Expenses

Direct MaterialDirect LaborFringe BenefitsPurchase Price VarianceScrapFreightInventory AdjustmentsSuppliesPackaging Expense

Total Variable Expenses

Contribution Margin%Period Costs

Manufacturing Salary LaborManufacturing Indirect LaborFringe BenefitsDepreciationRentInsuranceTaxesUtilitiesOther

Total Period Costs%

Gross Profit%SGA%Operating Income%

Direct Costing

Questions?

Direct Costing – Contact Infowww.sgcpa.com

Todd [email protected](608)836-7500

Rick [email protected](608)836-7500

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