Companies constantly update their products to stay ahead of the competition and maintain customer loyalty. But beyond the obvious costs that go into modifying your products — such as manufacturing and shipping — do you know what might impact your final profit margins? Before you commit to new product designs, take a direct costing approach to get a clearer picture of what those upgrades will actually cost you.
What is direct costing?
Direct costing is a specific type of cost analysis that looks at variable costs (also called incremental costs). When you use a direct costing approach to determine cost, you ignore fixed costs.
Direct costing looks only at variable costs, such as the actual costs involved in manufacturing a product or the costs to increase production. When manufacturing activities cease, so do variable costs. For example, shutting down a production line would eliminate all of the direct costs associated with making the product. Likewise, if an entire division closes, all the costs associated with that division are eliminated. Variable costs can include raw materials and direct labor.
Adding product options increases pricing complexity
As you introduce new products or add new features to existing products, your variable costs go up. New materials, components, vendors, and support functions increase your overhead. Every new part or variant that you add to your product portfolio drives up the cost of complexity. And you must eventually offset these increases by increasing prices or reducing costs.
Complexity can result from:
• New parts
• Tailored parts that interfere with standard parts
• Low-volume products that hinder production of high-volume products
• Inconsistent and variable designs that impact inventory management
Too much variety can affect your business functions and customers while compromising your costs, quality, and delivery. Unfortunately, many companies approve new products and features without understanding how these new variables will affect their bottom line.
As you can see in this example, as variable costs increase, the ultimate amount of operating income can decrease. Looking at your contribution margin will also give you a more accurate picture of true profitability; contribution margin is revenue minus variable costs.
Contribution margin will be explored in a future article; SG&A expense refers to selling, general, and administrative expense.
Benefits of using direct costing
Breaking out costs gives organizations a better grasp on the effect of the costs associated with each new product or feature. Using direct costing can help you reduce your overall number of transactions and associated reports because costs are easier to understand and more difficult to hide. Focusing on your final production costs makes it easier to plan based on actual costs.
While it’s important to keep your products fresh, it’s equally important to understand the costs and complexity that new features introduce. One of the keys to reducing complexity is to eliminate products that aren’t profitable enough.
Direct costing is a powerful tool that lets you see through the complexity of standard accounting methods. When you use direct costing in combination with data analytics, it can help you see how to improve your profitability.
Having trouble determining the true cost of your products? AlignAlytics can help you employ a direct costing approach to improve your profitability. Reach out to me below or or follow the author link.
Author: Patrick Mosimann