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Q.No.1:
Direct cost:
A cost that can be directly traced to producing specific goods or services.
For example, the cost of meat in a hamburger can be attributed directly to the cost of manufacturing that
product. Other costs, such as depreciation or administrative expenses, are more difficult to assign to a
specific product, and so are not considered direct costs.
Direct costing:
In Cost Accounting, method that includes only Variable Costs in the Cost of Goods Sold. The direct
costing method may not be used for tax purposes.
Difference between Direct cost and direct costing
Q.No.2:
Product Cost versus Period Cost:
Costs can also be classified as either product cost or period cost. To understand the difference between
product costs and period costs, we must first refresh our understanding of the matching principle from
financial accounting. Generally costs are recognized as expenses on the income statement in the period
that benefits from the cost. For example, if a company pays for liability insurance in advance for two
years, the entire amount is not considered an expense of the year in which the payment is made. Instead,
one half of the cost would be recognized as an expense each year. The reason is that both years-not just
the first year-benefit from the insurance payment. The un-expensed portion of the insurance payment is
carried on the balance sheet as an asset called prepaid insurance. You should be familiar with this type of
accrual from your financial accounting coursework.
The matching principle is based on the accrual concept and states that costs incurred to generate particular
revenue should be recognized as expense in the same period that the revenue is recognized. This means
that if a cost is incurred to acquire or make some thing that will eventually be sold, then the cost should be
recognized as an expense only when the sale takes place-that is, when the benefit occurs. Such costs are
called product costs.
Q.No.3:
Direct Costs:
For financial accounting purposes, product costs (Direct costs) include all the costs that are involved in
acquiring or making product. In the case of manufactured goods, these costs consist of direct materials,
direct labor, and manufacturing overhead. Product costs are viewed as "attaching" to units of product as
the goods are purchased or manufactured and they remain attached as the goods go into inventory
awaiting sale. So initially, product costs are assigned to an inventory account on the balance sheet. When
the goods are sold, the costs are released from inventory as expense (typically called Cost of Goods Sold)
and matched against sales revenue. Since product costs are initially assigned to inventories, they are also
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known as inventoriable costs. The purpose is to emphasize that product costs are not necessarily treated
as expense in the period in which they are incurred. Rather, as explained above, they are treated as
expenses in the period in which the related products are sold. This means that a product cost such as direct
materials or direct labor might be incurred during one period but not treated as an expense until a
following period when the completed product is sold.
The use of direct costing for financial reporting is not accepted by the accountant profession as a
Generally Accepted Accounting Principle. In addition the Securities and Exchange Commission refuses to
accept financial reports prepare on the basis of Direct Costing and the internally revenue service will not
permit the computation of Taxable Income on the direct costing basis. The position of theses groups is
generally based on their opposition to excluding the Fixed Costs from inventories.
Q.No.4:
The difference between the two income-measurement approaches is essentially the difference in the
timing of the charge to expense for fixed factory-overhead cost. In the absorption-costing method, fixed
factory overhead is first charged to inventory; thus, it is not charged to expense until the period in which
the inventory is sold and included in cost of goods sold (an expense). In contrast, in the variable-costing
method, fixed factory overhead is charged to expense immediately, and only variable manufacturing costs
are included in product inventories. Therefore, if inventories increase during a period (i.e., production
exceeds sales), the variable-costing method will generally report less operating income than will the
absorption-costing method; when inventories decrease, the opposite effect will take place.
Q.No.5:
Both generally accepted accounting principles and tax regulations require manufacturing companies to use
an absorption costing system. Under an absorption system, fixed manufacturing costs-both direct and
indirect-are treated as product costs. That is, they are assigned (or attached) to products during the
manufacturing process, and absorbed into inventory. They remain attached to the products in the work-inprocess inventory, and, subsequently, in the finished goods inventory, until the products are sold. At that
time they are removed from finished goods inventory, and placed on the income statement as part of cost
of goods sold.
A company that treated its fixed manufacturing costs as period costs, i.e., did not assign them to products
but expensed them on the income statement in the period when they were incurred, ordinarily would
receive a qualified opinion on its audited financial statements. In effect, by not attaching these costs to
products, and expensing them when the products are sold, it is violating the matching principle.
Absorption costing therefore must be used to value inventories for financial statements prepared under
Generally Accepted Accounting Principles (GAAP), and it must be used for tax computing purposes. This
does not mean that it must be used for managerial purposes, however. For internal reporting and control
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purposes, management can use any kind of information it wishes. There is only one criterion: the
information must be useful. Because of the complexities associated with absorption costing, many
companies have chosen to use something somewhat more intuitive, and therefore useful, for internal
purposes: variable costing.
The difference between the two types of costing lies exclusively in the treatment of the fixed portion of
manufacturing overhead. This is illustrated in Exhibit 8. As this exhibit indicates, absorption costing treats
fixed manufacturing overhead as a product cost, whereas variable costing treats it as a period cost.
As the following example shows, the difference between these two forms of costing can have a significant
impact on an organization's financial statements.
Example: Two companies are identical in every respect except one: Company A uses absorption costing, while
Company V uses variable costing. In Month 1, both companies produce and sell 1,000 units of their product. In Month
2, both companies produce 1,500 units of their product, but sell only 1,000 units. In Month 3, both companies produce
500 units, but sell 1,000 units (obtaining the remaining 500 units from the finished goods inventory left over at the
end of Month 2).
Period Costs:
Definition and Explanation of Period Costs:
Period costs are all the costs that are not included in product costs. These costs are expensed on the
income statement in the period in which they are incurred, using the usual rules of accrual accounting that
we learn in financial accounting. Period costs are not included as part of the cost of either purchased or
manufactured goods. Sales commissions and office rent are good examples of period costs. Both items are
expensed on the income statement in the period in which they are incurred. Thus they are said to be period
costs. Other examples of period costs are selling and administrative expenses.
Q.No.6:
There is no way to prove that one type of cost figure is going to be more helpful than another in the
determination of the sales price. The sales price must exceed all costs of every kind before a profit is
realized, but this does not mean that some sales of a single product or sales of products could not be made
at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed
expenses. The absorption or conventional cost approach to pricing looks at the long run total cost recovery.
The marginal costing or direct costing approach looks at the short run profit contribution aspect of
immediate sales. It seems probable that direct costing is more appropriate in making short run decisions
with regard to production schedules and pricing products offered for sales, provided the total cost recovery
in the long run is kept in mind.
Setting Prices in a Manufacturing Firm
How To Set Prices in a Manufacturing Firm
In setting prices, the goal should be to maximize profit. Although some owner-managers feel that an
increased sales volume is needed for increased profits, volume alone does not mean more profit. The
ingredients of profit are costs, selling price, and the unit sales volume. They must be in the proper
proportions if the desired profit is to be obtained.
No one set prices formula will produce the greatest profit under all conditions. To price for maximum
profit, the owner-manager must understand the different types of costs and how they behave. You
need the up-to-date knowledge of market conditions because the "right" selling price for a product
under one set of market conditions may be the wrong price at another time.
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The "best" price for a product is not necessarily the price that will sell the most units. Nor is it
always the price that will bring in the greatest number of sales dollars. Rather the "best" price is one
that will maximize the profits of the company.
The "best" selling price should be cost orientated and market orientated. It should be high enough to
cover your costs and help you make a profit. It should also be low enough to attract customers and
build sales volume.
Set Prices - A Four Layer Cake
In determining the best selling price, think of price as being like a four layer cake. The four elements
in your price are:
(1) the direct costs,
(2) manufacturing overhead,
(3) nonmanufacturing overhead, and
(4) profit.
Direct costs are fairly easy to keep in mind. They are the cost of the material and the direct labor
required to make a new product. You have these costs for the new product only when you make it.
On the other hand, even if you don't make the new product, you have manufacturing overhead such
as janitor service, depreciation of machinery, and building repairs, which must be charged to old
products. Similarly, nonmanufacturing overhead such as selling and administrative expenses
(including your salary) must be charged to your old products.
Direct Costing
The direct costing approach to setting prices enables you to start with known figures when you
determine a price for a new product. For example, suppose that you are considering a price for a
new product whose direct costs - materials and direct labor - are $3. Suppose further that you set
the price at $5. The difference ($5 minus $3 = $2) is "contribution." For each unit sold, $2 will be
available to help absorb your manufacturing overhead and your non-manufacturing overhead and to
contribute toward profit.
Price-Volume Relationship
Any price above $3 will make some contribution toward your overhead costs which are already there
whether or not you bring the product to market. The amount of contribution will depend on the
selling price which you select and on the number of units that you sell at that price. Look for a few
moments at some figures which illustrate this price-volume-contribution relationship:
Selling Price
$5
$4
$12
Sales in units
10,000
30,000
5,000
Sales
$50,000
$120,000
$60,000
Direct costs ($3 per unit)
$30,000
$90,000
$45,000
Contribution
_______
$20,000
_______
$30,000
_______
$15,000
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In this example, the $4 selling price, assuming that you can sell 30,000 units, would be the "best
price" for your product. However, if you could sell only 15,000 units at $4, the best price would be
$5. The $5 selling price would bring in a $20,000 contribution against the $15,000 contribution from
15,000 units at $4.
With these facts in mind, you can use a market-orientated approach to set your selling price. Your
aim is to determine the combination of selling price and unit volume which will provide the greater
contribution toward your manufacturing overhead, nonmanufacturing overhead, and profit.
Setting Prices Complications
If you ran a nonmanufacturing company and could get as much of a product as you could sell, using
the direct costing technique to determine your selling price would be fairly easy. Your success would
depend on how well you could project unit sales volume at varying selling prices.
However, in a manufacturing company, various factors complicate the setting of a price. Usually, the
quantity of a product that you can manufacture in a given time is limited. Also whether you ship
directly to customers or manufacture for inventory has a bearing on your production and financial
operation. Sometimes your production may be limited by labor. Sometimes by the availability of raw
materials. And sometimes by practices of your competition. You have to recognize such factors in
order to maximize your profits.
The direct costing concept enables you to key your pricing formula to that particular resource - labor,
equipment, or material - which is in the shortest supply. The Gail Manufacturing Company provides
an example.
Establish Contribution Percentage
In order to use the direct costing approach, Mr. Gail had to establish a contribution percentage. He
set it at 40 percent. From past records, he determined that, over a 12-month period, a 40-percent
contribution for each price would take care of manufacturing overhead and profit. In arriving at this
figure, Mr. Gail considered sales volume as well as overhead costs.
Determining the contribution percentage is a vital step in using the direct costing approach to
pricing. You should review your contribution percentage periodically to be sure that it covers all your
overhead (including interest on money you may have borrowed for new machines or for building an
inventory of finished products) and to be sure it provides for profit.
Mr. Gails' 40-percent contribution meant that direct costs - material and indirect labor - would be 60
percent of the selling price (100-40=60). Here is an example of how Mr. Gail computed his minimum
selling price:
Material
Direct labor
27c
+10c
_____
37c
The 37 cents was 60 percent of the selling price which worked out to 62 cents (37 cents divided by
60 percent). The contribution was 25 cents (40 percent of selling price):
Selling price
Direct costs
62c
-37c
_____
25c
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In this approach, raw material is given the same importance as direct labor in determining the
selling price.
Q.No.8:
Direct Costing - A concept of manufacturing cost accounting under which only costs that are a
consequence of production of a product are assigned to the product; all other costs are considered
expenses of the period in which they occurred.
"This may be described more briefly as a technique whereby the cost of product is restricted to the
inclusion of variable manufacturing costs with fixed manufacturing costs being considered as period
expenses."
Argument for Direct Costing
Simplicity - One argument for direct costing is its simplicity. One of the proposed advantages is the
elimination of allocations. Simplicity is welcome as long as the simplified accounting method is not
substantially less useful for internal managerial use as well as for use in reporting the operating results and
financial position.
Q.No.9:
Arguments against Direct Costing

Cost Allocation - Direct costing does not eliminate the necessity for cost allocations. There will
still remain within the area of product cost many elements that are directly assignable to units of
product – i.e., raw material and labor costs incurred before two or more joint products are split-off
and other variable overhead costs still require allocation.

Inventory Valuation - Using direct costing will result in lower inventory values compared to
full costing, however the arbitrary reduction adds little meaning to the financial statements. The
elimination of fixed manufacturing costs from product costs will result in the pricing of inventories
for financial statement purposes at amounts that bear no identifiable relationship with current
value.
LIFO
accounting
provides
the
same
undesirable
results.

Marginal Analysis - The basis for direct costing theory. Conclusions are only valid in the shortrun (a duration of time as not to permit any changes in the fixed plan employed by an enterprise).
Is management’s goal really profit maximization? Variable Costs vs. Fixed Costs.
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Summary
Manufacturing Costs
Direct Materials:
Materials that can be physically and conveniently
traced to a product, such as wood in a table.
Conversion Cost
Direct Labor +
Overhead Cost
Direct Labor:
Labor costs that can be physically and
conveniently traced to a product such as assembly
line workers in a plant. Direct labor is also called
touch labor cost.
Prime Cost
Direct Materials +
Direct Labor
Manufacturing Overhead:
All costs of manufacturing a product other than
direct materials and direct labor, such as indirect
materials, indirect labor, factory utilities, and
depreciation of factory equipment.
Nonmanufacturing Costs
Marketing or selling costs:
All costs necessary to secure customer orders and
get the finished product or service into the hands
of the customer, such as sales commission,
advertising, and depreciation of delivery
equipment and finished goods warehouse.
Administrative Costs:
All costs associated with the general management
of the company as a whole, such as executive
compensation, executive travel costs, secretarial
salaries, and depreciation of office building and
equipment.
Absorption Costing or Full Costing System:
Definition and explanation:
Absorption costing is a costing system which treats all costs of production as product costs, regardless weather
they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials,
direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing
overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing
includes all costs of production as product costs, it is frequently referred to as full costing method.
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Variable, Direct or Marginal Costing:
Definition and explanation:
Variable costing is a costing system under which those costs of production that vary with output are
treated as product costs. This would usually include direct materials, direct labor and variable portion of
manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing.
Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it
is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in
inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable
costing is some time referred to as direct costing or marginal costing. To complete this summary
comparison of absorption and variable costing, we need to consider briefly the handling of selling and
administrative expenses. These expenses are never treated as product costs, regardless of the costing
method in use. Thus under either absorption or variable costing, both variable and fixed selling and
administrative expenses are always treated as period costs and deducted from revenues as incurred.
The concepts explained so for are illustrated below:
Cost classifications--Absorption versus variable costing
Absorption
Costing
Variable
Costing
Direct materials
Direct Labor
Product cost Variable Manufacturing overhead
Product cost
Fixed manufacturing overhead
Period cost
Variable selling and administrative
expenses
Period cost
Fixed selling and administrative expenses
Unit Cost Computation/Calculation:
To illustrate the computation/calculation of unit product costs under both absorption and variable costing
consider the following example.
Example:
A small company that produces a single product has the following cost structure.
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Number of units produced
Variable costs per unit:
Direct materials
Direct labor
Variable manufacturing overhead
Variable selling and Administrative expenses
Fixed costs per year:
Fixed manufacturing overhead
Fixed selling and administrative expenses
$6,000
$2
$4
$1
$3
$30,000
$10,000
Required:
1. Compute the unit product cost under absorption costing method.
2. Compute the unit product cost under variable / marginal costing method.
Unit product Cost
Absorption Costing Method
Direct materials
$2
Direct labor
$4
Variable manufacturing overhead
$1
--------
Total variable production cost
$7
Fixed manufacturing overhead
$5
--------
Unit product cost
$12
======
Unit product Cost
Variable Costing Method
Direct materials
Direct labor
Variable manufacturing overhead
$2
$4
$1
---------Unit product cost
$7
======
(The $30,000 fixed manufacturing overhead will be charged off in
total against income as a period expense along with selling and
administrative expenses)
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Under the absorption costing, notice that all production costs, variable and fixed, are included when
determining the unit product cost. Thus if the company sells a unit of product and absorption costing is
being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income
statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance
sheet at $12 each.
Under variable costing, notice that all variable costs of production are included in product costs. Thus if
the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will
be carried in the balance sheet inventory account at only $7.
Income Comparison of Variable and Absorption Costing:
The income statements prepared under absorption costing and variable costing usually produce
different net operating income figures. This difference can be quite large. Here we will explain the basic
reason of this difference in income. The explanation for this difference needs two separate income
statements one under absorption costing and other under variable costing. We will prepare two income
statements that will produce different income figures and then explain the reasons of difference. Consider
the following example:
Example:
Following data relates to a manufacturing company:
Number of units produced each year
Variable cost per unit:
Direct materials
Direct labor
Variable Manufacturing Overhead
Variable selling and Administrative expenses
Fixed costs per year:
Fixed manufacturing overhead
Fixed selling and administrative expenses
Units in beginning inventory
Units produced
Units Sold
Units in ending inventory
Selling price per unit
60,000
$2
$4
$1
$3
$30,000
$10,000
0
6,000
5,000
1,000
$20
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Selling and administrative expenses:
Variable per unit
Fixed per year
$3
$10,000
Required:
1. Prepare income statements using:
a. Absorption costing system
b. Variable costing system
2. Prepare a reconciliation schedule
Absorption Costing Income Statement
Sales (5,000 units×$20 per unit)
Less cost of goods sold:
Beginning inventory
Add Cost of goods manufactured (6,000 units×$12per unit)
Goods avail able for sale
Less ending inventory
Cost of goods sold
Gross Margin ($100,000 – $60,000)
Less selling and administrative expenses
Variable selling and administrative expenses (5,000 × 3)
Fixed selling and administrative expenses
Net operating income ($40,000 – $25,000)
Variable Costing Income Statement
Sales ($5,000units×$20 per unit)
Less variable expenses:
Variable cost of goods sold:
Beginning inventory
Add variable manufacturing costs (1,000 units×$7 per unit)
Goods available for sale
$100,000
--------------$0
$72,000
---------------$72,000
$12,000
----------------$60,000
----------------$40,000
---------------$15,000
$10,000
---------------$25,000
---------------$15,000
=========
$100,000
$0
$42,000
--------------$42,000
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Less ending inventory (1,000 units×$7 per unit)
Variable cost of goods sold
variable selling and administrative expenses
(5,000 units × $3 per unit)
Contribution margin ($100,000 − $50,000)
Less fixed expenses:
Fixed manufacturing overhead
Fixed selling and administrative expenses
Net operating Income ($50,000 − $40,000)
$7,000
--------------$35,000
$15,000
----------------50,000
--------------50,000
--------------$30,000
$10,000
--------------$40,000
--------------$10,000
========
The income statements prepared above have different net operating income figures. Now we will explain
why net operating income is different under both the costing systems.
Explanation:
Several points can be noted from the income statements prepared above:
Under absorption costing if inventories increase then some of the fixed manufacturing costs of the current
period will not appear on the income statement as part of cost of goods sold. Instead, these costs are
deferred to a future period and are carried on the balance sheet as part of the inventory account. Such a
deferral of cost is known as fixed manufacturing overhead deferred in inventory. The process involved can
be explained by referring to income statements prepared above. During the current period 6,000 units have
been produced but only 5,000 units have been sold leaving 1,000 unsold units in the ending inventory.
Under the absorption costing system each unit produced was assigned $5 in fixed overhead cost.
Therefore each unit going into inventory at the end of the period has $5 in fixed manufactured overhead
cost attached to it, or a total of $5,000 for 1,000 units (1,000 × $5). This fixed manufacturing overhead
cost of the current period deferred in inventory to the next period, when hopefully these units will be taken
out of inventory and sold. This deferral of $5,000 of fixed manufacturing overhead costs can be clearly
seen by analyzing the ending inventory under the absorption costing method:
Variable manufacturing costs (1000units × $7 per unit)
Fixed manufacturing overhead costs (1,000 × $5 per unit)
Total ending inventory value
$7,000
$5,000
--------$12,000
=======
In summary, under absorption costing, of the $30,000 in fixed manufacturing overhead costs incurred
during the period, only $25,000 (5,000 $ per unit) has been included in the cost of goods sold. The
remaining $5000 (1000 units not sold $5 per unit) has been deferred in inventory to the next period.
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Under variable costing method the entire $30,000 in fixed manufacturing overhead costs has been
treated as an expense of the current period (see the bottom portion of the variable costing income
statement).
The ending inventory figure under the variable costing method is $5,000 lower than it is under the
absorption costing method. The reason is that under variable costing, Only the variable manufacturing
costs are assigned to units of product and therefore included in the inventory:
Variable manufacturing costs (1000units × $7 per unit)
$7,000
The $5,000 difference in ending inventories explains the difference in net operating income reported
between the two costing methods. Net operating is $5,000 higher under absorption costing since, as
explained above, $5,000 of fixed manufacturing overhead cost has been deferred in inventory to the next
period under that costing method. Hopefully, when the units relating to this $5,000 fixed cost will be sold
in the next period the cost attached to these units will be included in the cost of goods sold of the next
period. This is called fixed manufacturing overhead cost released from inventory.
The absorption costing system makes no distinction between fixed and variable costs; therefore, it is not
well suited for CVP computations, which are important for good planning and control. To generate data
for cost volume profit (CVP) analysis, it would be necessary to spend considerable time reworking and
reclassifying costs on the absorption statement.
The variable costing approach to costing units of product works very well with the contribution approach
to the income statement, since both concepts are based on the idea of classifying costs by behavior. The
variable costing data could be immediately used in CVP computations.
Limitations of Variable Costing--GAAP and External Reports:
Practically speaking, absorption costing is required for external reports in United States and almost all
over the world. A company that attempts to use variable costing (also called direct costing and marginal
costing) on its external financial reports runs the risk that its auditors may not accept the financial
statements as conforming to generally accepted accounting principles (GAAP). Tax laws almost all
over the world require the usage of a form of absorption costing for filling out income tax forms.
Even if a company must use absorption costing for its external reports, a manager can use variable
costing statements for internal reports. No particular accounting problems are created by using both
costing methods--the variable costing method for internal reports and the absorption costing method for
external reports. The adjustment from variable costing net operating income to absorption costing net
operating income is a simple one that can be easily made at year-end.
Top executives are typically evaluated based on the earnings reported to shareholders on the external
financial reports. This creates a problem for top executives who might otherwise favor using variable
costing for internal reports. They may feel that since they are evaluated based on absorption costing
reports, decisions should also be based on absorption costing data.
Q.
Select the answer which best completes the statement: See answer
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(a)
The term meaning that all manufacturing costs (direct and indirect, fixed and variable) which
contribute to the production of the product and traced to output and inventories is: (1) job order
costing; (2) process costing; (3) absorption costing; (4) direct costing.
(b)
The term that is most descriptive of the type of cost accounting often called direct costing is (1) out
of pocket costing; (2) variable costing; (3) relevant costing; (4) prime costing.
(c)
Costs treated as product costs under direct costing are: (1) prime costs only; (2) variable production
costs only; (3) all variable costs; (4) all variable and fixed manufacturing costs.
(d)
The basic assumptions made in direct costing with respect to fixed costs is that fixed cost is: (1)
controllable cost; (2) a product cost; (3) an irrelevant cost; (4) a period cost
(e)
(g)
(h)
Operating income computed using direct costing would generally exceed operating income
computed using absorption costing if: (1) units sold exceed units produced; (2) units sold are less
than units produced; (3) units sold equal units produced; (4) the unit fixed cost is zero
Absorption costing differs from direct costing in the: (1) fact that standard costs can be used with
absorption costing but not with direct costing; (2) kinds of activities for which each can be used to
report ; (3) amounts of costs assigned to individual units of product; (4) amount of fixed costs that
will be incurred.
When a firm uses direct costing: (1) the cost of a unit of product changes because of changes in the
number of units manufactured; (2) profits fluctuate with sales; (3) an idle capacity variance is
calculated by a direct costing system; (4) product cost include variable administrative costs.
(i)
Operating income under absorption costing can be reconciled to operating income determined under
direct costing by computing the difference between: (1) inventoried fixed costs in the beginning and
ending inventories and any deferred over or under applied fixed factory overhead; (2) inventoried
discretionary costs in the beginning and ending inventories; (3) gross profit (absorption costing
method) and contribution margin (direct costing method); (4) sales as recorded under the direct
costing method and sales as recorded under the absorption costing method.
(j)
Under the direct costing concept, unit product cost would most likely be increased by: (1) a decrease
in the remaining useful life of factory machinery depreciated by the units of production method; (2)
a decrease in the number of units produced; (3) an increase in the remaining useful life of factory
machinery depreciated by the sum of the years digits method; (4) an increase in the commission
paid to salespersons for each units sold.
(k)
When using direct costing information, the contribution margin discloses the excess of: (1) revenue
over fixed cost; (2) projected revenue over the break even point; (3) revenue over variable cost; (4)
variable cost over fixed cost.
Answers:
(a) 3
(b) 2
(c) 2
(d) 4
(e) 1
(f) 3*
(g) 3
(h) 2
(i) 1
(j) 1
(k) 3
*Operating income under direct costing + Cost deferred in inventory
$50,000 + $10,000
$60,000
Q. Why is it said that an income statement prepared by the direct costing procedure is more helpful
to management than an income statement prepared by the absorption costing method?
An income statement prepared by the direct costing method presents cost of goods sold figures with
variable costs only. These variable costs, based on the number of units sold, facilitate computing a
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contribution margin figure. Thus the direct costing income statement is preferred by the management
because it follows management's decision making processes more closely that the statement based on
absorption costing.
Q. In the process of determining a proper sales price, what kind of cost figures is likely to be most
helpful?
There is no way to prove that one type of cost figure is going to be more helpful than another in the
determination of the sales price. The sales price must exceed all costs of every kind before a profit is
realized, but this does not mean that some sales of a single product or sales of products could not be made
at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed
expenses. The absorption or conventional cost approach to pricing looks at the long run total cost
recovery. The marginal costing or direct costing approach looks at the short run profit contribution aspect
of immediate sales. It seems probable that direct costing is more appropriate in making short run decisions
with regard to production schedules and pricing products offered for sales, provided the total cost recovery
in the long run is kept in mind.