A direct cost is a price that can be directly tied to the production of specific goods or services. A direct cost can be traced to the cost object, which can be a service, product, or department. Direct and indirect costs are the two major types of expenses or costs that companies can incur. Direct costs are often variable costs, meaning they fluctuate with production levels such as inventory. However, some costs, such as indirect costs are more difficult to assign to a specific product. Examples of indirect costs include depreciation and administrative expenses. Show
1:15 Direct CostUnderstanding Direct CostsAlthough direct costs are typically variable costs, they can also include fixed costs. Rent for a factory, for example, could be tied directly to the production facility. Typically, rent would be considered overhead. However, companies can sometimes tie fixed costs to the units produced in a particular facility. Direct Costs ExamplesAny cost that's involved in producing a good, even if it's only a portion of the cost that's allocated to the production facility, are included as direct costs. Some examples of direct costs are listed below:
Because direct costs can be specifically traced to a product, direct costs do not need to be allocated to a product, department, or other cost objects. Direct costs usually benefit only one cost object. Items that are not direct costs are pooled and allocated based on cost drivers. Direct and indirect costs are the major costs involved in the production of a good or service. While direct costs are easily traced to a product, indirect costs are not. Key Takeaways
Direct vs. Indirect CostsDirect costs are fairly straightforward in determining their cost object. For example, Ford Motor Company (F) manufactures automobiles and trucks. The steel and bolts needed for the production of a car or truck would be classified as direct costs. However, an indirect cost would be the electricity for the manufacturing plant. Although the electricity expense can be tied to the facility, it can't be directly tied to a specific unit and is, therefore, classified as indirect. Fixed vs. VariableDirect costs do not need to be fixed in nature, as their unit cost may change over time or depending on the quantity being utilized. An example is the salary of a supervisor that worked on a single project. This cost may be directly attributed to the project and relates to a fixed dollar amount. Materials that were used to build the product, such as wood or gasoline, might be directly traced but do not contain a fixed dollar amount. This is because the quantity of the supervisor's salary is known, while the unit production levels are variable based upon sales. Inventory Valuation MeasurementUsing direct costs requires strict management of inventory valuation when inventory is purchased at different dollar amounts. For example, the cost of an essential component of an item being manufactured may change over time. As the item is being manufactured, the component piece's price must be directly traced to the item. For example, in the construction of a building, a company may have purchased a window for $500 and another window for $600. If only one window is to be installed on the building and the other is to remain in inventory, consistent application of accounting valuation must occur. Companies typically trace these costs using two methods: first-in, first-out (FIFO) or last-in, first-out (LIFO). FIFO involves the assigning of costs, such as the purchase of inventory, based on what items arrived first. As inventory is used up in the production of goods, the first ones or the oldest inventory items are used first when measuring the cost of the item. Conversely, LIFO assigns the value of a cost item based on the last item purchased or added to inventory. Direct costing is a specialized form of cost analysis that only uses variable costs to make decisions. It does not consider fixed costs, which are assumed to be associated with the time periods in which they were incurred. The direct costing concept is extremely useful for short-term decisions, but can lead to harmful results if used for long-term decision making, since it does not include all costs that may apply to a longer-term decision. In brief, direct costing is the analysis of incremental costs. Direct costs are most easily illustrated through examples, such as:
The examples show that direct costs can vary based upon the level of analysis. For example, if you are reviewing the direct cost of a single product, the only direct cost may be the materials used in its construction. However, if you are contemplating shutting down an entire company, the direct costs are all costs incurred by that company – including all of its production and administrative costs. The main point to remember is that a direct cost is any cost that changes as the result of either a decision or a change in volume. When to Use Direct CostingDirect costing is of great use as an analysis tool. The following decisions all involve the use of direct costs as inputs to decision models. They contain no allocations of overhead, which are not only irrelevant for many short-term decisions, but which can be difficult to explain to someone not trained in accounting.
Problems with Direct CostingDirect costing is an analysis tool, but it is only usable for certain types of analysis. In some situations, it can provide incorrect results. This section describes the key issues with direct costing that you should be aware of. They are:
Direct costing is an excellent analysis tool. It is almost always used to create a model to answer a question about what actions management should take. It is not a costing methodology for constructing financial statements – in fact, accounting standards specifically exclude direct costing from financial statement reporting. Thus, it does not fill the role of a standard costing, process costing, or job costing system, which contribute to actual changes in the accounting records. Instead, it is used to extract pertinent information from a variety of sources and aggregate the information to assist management with any number of tactical decisions. It is most useful for short-term decisions, and least useful when a longer-term time frame is involved - especially in situations where a company must generate sufficient margins to pay for a large amount of overhead. Though useful, direct costing information is problematic in situations where incremental costs may change significantly, or where indirect costs may be pertinent to the decision. Which of the following statement is correct using direct costing concept?Under direct costing, variable manufacturing costs are included in the cost of goods manufactured. All other costs, including fixed costs, are considered period costs. Use of direct costing methods is for management use only and cannot be used in the preparation of financial statements. The correct answer is d.
What is the direct costing?A direct cost is a price that can be directly tied to the production of specific goods or services. A direct cost can be traced to the cost object, which can be a service, product, or department. Direct costs examples include direct labor and direct materials.
Which one of the following statement is correct regarding absorption costing variable costing?Answer and Explanation: The correct statement about absorption and variable costing methods is option C. If the units produced are above the units sold, the company will have ending inventory units at the end.
Which of the following cost accounting terminology is commonly referred to as direct costing?Which of the following is a term more descriptive of the type of cost accounting often called direct costing? Variable Costing. Which of the following is an argument against the use of variable costing? Fixed manufacturing overhead is necessary for the production of a product.
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