Two costing experts discuss using direct costing techniques to understand the true cost of products or services. These ideas can help businesses be more competitive in pricing their products and services.

1. Direct Costing
Todd Kleibor, CPA, CMA
Rick Magnuson
Smith & Gesteland, LLP

2. 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.

3. 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.

4. Learning Objectives
• Understand the current state of costing

5. Learning Objectives
• Provide an overview of direct costing

6. Learning Objectives
• Understand the benefits of direct costing

7. Learning Objectives
• Direct costing in application – case studies

8. Learning Objectives
• Keys to successfully implementing direct
costing

9. 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

10. 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)

11. 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

12. What is Direct Costing? (continued)
– Variable costs
• Direct materials
• Direct labor
• Fringe benefits
• Purchase price variance
• Scrap
• Freight
• Inventory adjustments
• Supplies
• Packaging
• Etc.

13. 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

14. 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

15. 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

16. 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?

17. 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?

18. Direct Costing - Case Study - Two
Product Sales
Price
Direct
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?

19. Direct Costing - Case Study - Three
Income Statement impact
– Full Absorption
January February
Sales $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 –
($25,000) ($20,000)
Applied
($5,000) $-0-
Gross Profit $25,000 $25,000
Inventory $5,000 -0-
Income Statement impact
– Direct Costing
January February
Sales $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-

20. Direct Costing - Case Study
Your Largest Customer Wants a 10% Price Reduction
Income Statement impact
– Full Absorption
January February
Sales $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 –
($25,000) ($20,000)
Applied
($5,000) $-0-
Gross Profit $25,000 $25,000
Inventory $5,000 -0-
Income Statement impact
– Direct Costing
January February
Sales $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-

21. Direct Costing – Case Study – Four
Contrasting 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 March
Machines produced 4 5 3
Machines sold 4 4 4
Inventory, end of
- 1 -
month

22. Direct Costing – Case Study – Four
Contrasting Direct Costing & Absorption Costing
Absorption Costing Direct Costing
Jan 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
- - - 50 50 50
(period costs)
SGA 20 20 20 20 20 20
Net Profit 20 30 10 20 20 20
Inventory, End of
Period
- 25 - - 15 -

23. 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

24. 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

25. Direct Cost – Income Statement Format
Revenues
Variable Expenses
Direct Material
Direct Labor
Fringe Benefits
Purchase Price Variance
Scrap
Freight
Inventory Adjustments
Supplies
Packaging Expense
Total Variable Expenses
Contribution Margin
%
Period Costs
Manufacturing Salary Labor
Manufacturing Indirect Labor
Fringe Benefits
Depreciation
Rent
Insurance
Taxes
Utilities
Other
Total Period Costs
%
Gross Profit
%
SGA
%
Operating Income
%

26. Direct Costing
Questions?

27. Direct Costing – Contact Info
www.sgcpa.com
Todd Kleibor
Todd.Kleibor@sgcpa.com
(608)836-7500
Rick Magnuson
Rick.Magnuson@sgcpa.com
(608)836-7500
Please take a moment to complete a short survey