BFTECH (IDM)

END TERM ASSESSMENT

COSTING IN
APPAREL
MANUFACTUR
ING

CO TING
Direct Costing, Absorption
Costing and Activity Based
Costing.

Presented To Presented by
Sumit Sir Aparna Patel
7th sem
IDM (BFtech)
 What is Direct Costing?
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 costs actually consumed when you manufacture a product

The incremental increase in costs when you ramp up production
The costs that disappear when you shut down a production line
The costs that disappear when you shut down an entire subsidiary

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.

Advantage Direct Costing?

Direct 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..
 Advantage Direct Costing?
Direct 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..
Automation investments. A common scenario is for a company to
invest in automated production equipment in order to reduce the
amount it pays to its direct labor staff. Under direct costing, the key
information to collect is the incremental labor cost of any employees
who will be terminated, as well as the new period costs to be incurred
as part of the equipment purchase, such as the depreciation on the
equipment and maintenance costs.
Cost reporting. Direct costing is very useful for controlling variable
costs, because you can create a variance analysis report that
compares the actual variable cost to what the variable cost per unit
should have been. Fixed costs are not included in this analysis, since
they are associated with the period in which they are incurred, and so
are not direct costs.
Customer profitability. Some customers require a great deal of
support, but also place such large orders that a company still earns a
considerable profit from the relationship. If there are such resource-
intensive situations, it makes sense to occasionally calculate how
much money the company really earns from each customer. This
analysis may reveal that the company would be better off eliminating
some of its customers, even if this results in a noticeable revenue
decline.
Internal inventory reporting. Generally accepted accounting principles
and international financial reporting standards require that a company
allocate indirect costs to its inventory asset for external reporting
purposes.
Overhead allocation can require a prolonged amount of time to complete, so
it is relatively common for company controllers to avoid updating the
overhead allocation during reporting periods when there will be no external
reporting. Instead, they rely mostly on direct cost updates, and either avoid
all changes to the overhead allocation, or make an approximate guess at the
correct overhead allocation
based on a proportion of direct costs, and make a more accurate
adjustment when a reporting period arrives for which the company must
report financial statements to outside parties.
Profit-volume relationship. Direct costing is useful for plotting changes in
profit levels as sales volumes change. It is relatively simple to create a
direct costing table that points out the volume levels at which additional
direct costs will be incurred, so that management can estimate the
amount of profit at different levels of corporate activity.
Outsourcing. Direct costing is useful for deciding whether to manufacture
an item in-house or maintain a capability in-house, or whether to
outsource it. If the decision involves manufacturing in-house or
elsewhere, it is crucial to determine how many staff and which machines
will actually be eliminated; in many cases, these resources are simply
shifted elsewhere within the company, so there is no net profit
improvement by shifting production to a supplier.

Disdvantage Direct Costing?

Direct 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:
External reporting. Direct costing is prohibited for the reporting of inventory
costs under both generally accepted accounting principles and international
financial reporting standards. This means that you cannot report the cost of
inventory as though it only includes direct costs; you must also include a
proper allocation of indirect costs. If you used direct costing for external
reporting, then fewer costs would be included in the inventory asset on the
balance sheet, resulting in more costs being charged to expense in the
current period.

Increasing costs. Direct costing is sometimes targeted at whether to

increase production by a specific amount in order to accept an additional
customer order. For the purposes of this specific decision, the analyst
usually assumes that the direct cost of the decision will be the same as
the historical cost. However, the cost may actually increase. For
example, if a machine is already running at 80% of capacity and a
proposed decision will increase its use to 90%, this incremental
difference may very well result in a disproportionate increase in the
maintenance cost of the machine. Thus, be aware that a specific direct
costing scenario may contain costs that are only relevant within a narrow
range; outside of that range, costs may be substantially different.
Indirect costs. Direct costing does not account for indirect costs, because
it is designed for short-term decisions where indirect costs are not
expected to change. However, all costs change over the long term, which
means that a decision that can impact a company over a long period of
time should address long-term changes in indirect costs. Consequently, if
a company uses an ongoing series of direct cost analyses to drive its
pricing decisions, it may end up with an overall pricing structure that is
too low to pay for its overhead costs.
Relevant range. A direct costing analysis is usually only valid within the
constraints of the current capacity level. It requires a more sophisticated
form of direct costing analysis to account for changes in costs as sales
volumes or production volumes increase.
 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.

Terms Similar to Direct Costing

Direct costing is also known as variable costing, contribution costing, and

marginal costing.
 What Is Absorption Costing?
Absorption costing, sometimes called “full costing,” is a managerial
accounting method for capturing all costs associated with
manufacturing a particular product. The direct and indirect costs,
such as direct materials, direct labor, rent, and insurance, are
accounted for by using this method.

Absorption costing is required by generally accepted accounting

principles (GAAP) for external reporting.

Absorption costing differs from variable costing because it

allocates fixed overhead costs to each unit of a product
produced in the period.
Absorption costing allocates fixed overhead costs to a product
whether or not it was sold in the period.
This type of costing method means that more cost is included in
the ending inventory, which is carried over into the next period
as an asset on the balance sheet.
Because more expenses are included in ending inventory,
expenses on the income statement are lower when using
absorption costing.
 Understanding Absorption Costing

Absorption costing includes anything that is a direct cost in

producing a good in its cost base. Absorption costing also includes
fixed overhead charges as part of the product costs. Some of the
costs associated with manufacturing a product include wages for
employees physically working on the product, the raw materials
used in producing the product, and all of the overhead costs (such
as all utility costs) used in production.
In contrast to the variable costing method, every expense is
allocated to manufactured products, whether or not they are sold by
the end of the period.

Advantages and Disadvantages of

Absorption Costing

Assets, such as inventory, remain on the entity’s balance sheet at

the end of the period. Because absorption costing allocates fixed

overhead costs to both cost of goods sold and inventory, the costs
associated with items still in ending inventory will not be captured in
the expenses on the current period’s income statement. Absorption
costing reflects more fixed costs attributable to ending inventory.
Absorption costing ensures more accurate accounting for ending
inventory because the expenses associated with that inventory are
linked to the full cost of the inventory still on hand. In addition, more
expenses are accounted for in unsold products, which reduces
actual expenses reported in the current period on the income
statement. This results in a higher net income calculation compared
with variable costing calculations.

Because absorption costing includes fixed overhead costs in the

cost of its products, it is unfavorable compared with variable costing
when management is making internal incremental pricing decisions.
This is because variable costing will only include the extra costs of
producing the next incremental unit of a product.

In addition, the use of absorption costing generates a situation in

which simply manufacturing more items that go unsold by the end of
the period will increase net income. Because fixed costs are spread
across all units manufactured, the unit fixed cost will decrease as
more items are produced. Therefore, as production increases, net
income naturally rises, because the fixed-cost portion of the cost of
goods sold will decrease.
 Activity-Based Costing (ABC)

Activity-based costing (ABC) is a costing method that assigns

overhead and indirect costs to related products and services. This

accounting method of costing recognizes the relationship between

costs, overhead activities, and manufactured products, assigning

indirect costs to products less arbitrarily than traditional costing

methods. However, some indirect costs, such as management and
office staff salaries, are difficult to assign to a product.
Activity-based costing (ABC) is mostly used in the manufacturing
industry since it enhances the reliability of cost data, hence
producing nearly true costs and better classifying the costs incurred
by the company during its production process.

KEY TAKEAWAYS
Activity-based costing (ABC) is a method of assigning overhead
and indirect costs—such as salaries and utilities—to products
and services.
The ABC system of cost accounting is based on activities, which
are considered any event, unit of work, or task with a specific
goal.
An activity is a cost driver, such as purchase orders or machine
setups.
The cost driver rate, which is the cost pool total divided by cost
driver, is used to calculate the amount of overhead and indirect
costs related to a particular activity.
ABC is used to get a better grasp on costs, allowing companies to
form a more appropriate pricing strategy.
This costing system is used in target costing, product costing,
product line profitability analysis, customer profitability analysis, and
service pricing. Activity-based costing is used to get a better grasp
on costs, allowing companies to form a more appropriate pricing
strategy.
The formula for activity-based costing is the cost pool total divided
by cost driver, which yields the cost driver rate. The cost driver rate
is used in activity-based costing to calculate the amount of overhead
and indirect costs related to a particular activity.

The ABC calculation is as follows:

1. Identify all the activities required to create the product.

2. Divide the activities into cost pools, which includes all the
individual costs related to an activity—such as manufacturing.
Calculate the total overhead of each cost pool.
3. Assign each cost pool activity cost drivers, such as hours or
units.
4. Calculate the cost driver rate by dividing the total overhead in
each cost pool by the total cost drivers.
5. Divide the total overhead of each cost pool by the total cost
drivers to get the cost driver rate.
6. Multiply the cost driver rate by the number of cost drivers.
ABC is used to get a better grasp on costs, allowing companies to
form a more appropriate pricing strategy.
This costing system is used in target costing, product costing,
product line profitability analysis, customer profitability analysis, and
service pricing. Activity-based costing is used to get a better grasp
on costs, allowing companies to form a more appropriate pricing
strategy.

Advantage of Activity-Based Costing

Activity-based costing (ABC) enhances the costing process in three
ways. First, it expands the number of cost pools that can be used to
assemble overhead costs. Instead of accumulating all costs in one
company-wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items

such that costs are allocated based on the activities that generate
costs instead of on volume measures, such as machine hours or
direct labor costs.

Finally, ABC alters the nature of several indirect costs, making costs
previously considered indirect—such as depreciation, utilities, or
salaries—traceable to certain activities. Alternatively, ABC transfers
overhead costs from high-volume products to low-volume products,
raising the unit cost of low-volume products.
Uses for Activity-Based Costing (ABC)
The ABC system of cost accounting is based on activities, which are
any events, units of work, or tasks with a specific goal, such as
setting up machines for production, designing products, distributing
finished goods, or operating machines. Activities consume overhead
resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any

transaction or event that is a cost driver. A cost driver, also known
as an activity driver, is used to refer to an allocation base. Examples
of cost drivers include machine setups, maintenance requests,
consumed power, purchase orders, quality inspections, or
production orders.

There are two categories of activity measures: transaction drivers,

which involves counting how many times an activity occurs, and
duration drivers, which measure how long an activity takes to
complete.