Direct Cost versus Absorption Accounting

Under direct costing, only about a third of the costs would be placed in inventory (25 percent). The fixed costs are charged to the income statement immediately (45 percent). Note that making an item for inventory requires the company to lay out cold, hard cash for direct material (25 percent). This expenditure is at risk if demand for the production does not materialize. If production is deferred, the direct material is saved until it is actually needed by the market. 

Direct costs also approximate the marginal cost incurred by producing one more unit. This has important implications for decisions regarding pricing. A case illustrates the point. The general manager of a housewares company, an accountant, faced a dilemma. His best customer at the time, retailer Sears, had offered a deal that made him uncomfortable. 

Because the stepstool was the highest-volume product in the plant, the organization had become quite proficient in producing it. However, the overhead rate was full of costs for inefficiencies incurred in making lower-volume products. In effect, the efficient stepstool production subsidized the inefficient products. Actual variable costs for the stepstool were 5. With fully absorbed costs, the client would appear to lose 2 on every unit. In direct costing, the client would put 3 in his pocket. Despite this, he refused Sears offer. 

No company — or supply chain, for that matter — will stay in business if it just covers direct costs. They must recover fixed costs as well. But awareness of direct costing and its impact on behavior is important to supply chain decisions on pricing and investments. A decision to participate as a supply chain partner should consider direct costs and contribution to profit. In our Acme case study (see Chapter 10), the company chose to focus on high contribution, as opposed to high contribution margin business as part of its strategy. If our houseware executive had followed the same path, the company would have taken the Sears offer. 

Absorption costing is a factor in decisions to pack work into production schedules near the end of accounting periods. If management believes it will be short of its goals, it might make more stuff betting that it can be sold at some point. Fixed costs will be absorbed, and reported profit will improve for that period. This will also put off the day of reckoning if the stuff they make does not sell. 

Separation of Old Line s Costs into Variable and Fixed Components 

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