Purpose of direct costing
Costs are of two kinds. Variable costs change with the number of units made (material, piece-rate labour). Fixed costs stay the same in a period (rent, salaries, machine depreciation).
Direct costing (also called variable costing) counts only variable costs as the cost of a product. Fixed costs are not put into stock. They are charged in full to the period.
Why do this? Managers see at once how much each extra unit earns, and profit moves only when sales move, not when production moves.
Direct costing income statement
The statement is written in the contribution format:
- Sales
- less variable costs = contribution margin
- less fixed costs = operating profit
Stock is valued at variable cost only. Outside reports (tax, banks, annual accounts) usually need absorption costing, so firms convert one to the other at the period end.
Direct costing vs absorption costing
Absorption costing adds a share of fixed cost to every unit made: fixed cost per unit = fixed cost ÷ units made. Unsold units sit in stock with this share inside.
Profit difference = fixed cost per unit × change in stock units.
- Stock goes up (made > sold): absorption profit is higher.
- Stock goes down (made < sold): absorption profit is lower.
- Made = sold: both profits are equal.
Use in short-term profit planning
Because contribution is shown clearly, direct costing is the base of short-term planning. Break-even sales = fixed cost ÷ contribution per unit. Target sales = (fixed cost + target profit) ÷ contribution per unit. It also helps in decisions such as accepting a special order or dropping a product: if a product still gives positive contribution, it helps pay the fixed costs.
Key formulas and definitions
- Contribution = Sales - Variable costs
- Operating profit = Contribution - Fixed costs
- Fixed cost per unit (absorption) = Fixed cost ÷ Units made
- Profit gap = Fixed cost per unit × (Units made - Units sold)
- Break-even units = Fixed cost ÷ Contribution per unit
Worked examples
1. Sales $2,000, variable costs $800, fixed costs $1,000. Find the direct costing profit.
Contribution = 2,000 - 800 = 1,200. Profit = 1,200 - 1,000 = $200.
2. Price $10, variable cost $4 per pen. Fixed cost $1,000. 300 pens made, 200 sold. Find absorption profit.
Fixed cost per pen = 1,000 ÷ 300 = 3.33. Cost per pen = 4 + 3.33 = 7.33. Profit = 200 × (10 - 7.33) = about $533.
3. Same facts. Find the difference between the two profits.
Direct profit = 200 × 6 - 1,000 = 200. Absorption = 533. Gap = 333. Check: 3.33 × (300 - 200) = 333.
4. If all 300 pens are sold, what are both profits?
Direct: 300 × 6 - 1,000 = 800. Absorption: 300 × (10 - 7.33) = 800. Equal, because no stock is left.
5. Only 100 pens are sold out of 300. Find both profits.
Direct: 100 × 6 - 1,000 = -400 (loss). Absorption: 100 × 2.67 = about $267 profit. Gap = 3.33 × 200 = 667.
6. Last month stock rose by 500 units. Fixed cost per unit was $2. By how much was absorption profit higher?
2 × 500 = $1,000 higher than direct costing profit.
Common mistakes
- Putting fixed costs into the unit cost under direct costing. They are charged to the period.
- Forgetting that stock is valued at variable cost only in direct costing.
- Saying the two methods always give different profits. They are equal when units made equal units sold.
- Mixing up the sign: more stock means absorption profit is higher, not lower.