Direct cost is the amount accredited for production of some goods or provision of services. In other words in a production process of a product, cost of labor, material and other expenses related to this production calls direct cost. Direct cost is related directly to the volume of production. It must be noted that the material cost is included in direct cost but cost of machinery is not a part of it. In this context, direct cost can be defined as the process of determining direct cost included in an operation or production.
Applications of Direct Costing
Direct costing can be used very effectively to get valuable information regarding prospective changes in production costs which will come up as a result of some management action. A few good examples of applications of direct costing include:
- Equipment is updating
If management is looking to upgrade old machinery and equipment or purchase of modern machinery, direct costing can give an idea how this machine will affect their direct cost. A new machine may be costly but overall it could reduce direct cost of production by decreasing labor, loss of material and better performance.
- Price Setting
Another important use of direct costing could be a determination of lowest possible cost that must be charged to customers or clients in order to remain at break even.
- Profitability Analysis
Direct costing can be applied for the determination of profitability of various clients by deducting direct cost of their purchase price. One can find the contributions of various clients towards company’s profits and overhead and comparison can be easily made.
Direct costing also help in creating a budgeting system by using it to change budget variable costs to match the volumes of actual sale achieved.
Limitation of Direct Costing
Although direct costing has many applications, still there are some limitations. One is ignorant of indirect costs. Therefore the use of direct costing is not highly advisable for calculating long-term profitability. Ignoring huge indirect costs could lead to inaccurate results of long term costing and pricing decisions.