Direct costs refer to the unavoidable expenses incurred when honoring a contract. When there is a contractual business relationship, the company is supposed to provide finished goods in exchange for the financial reward that the customer will offer. There are many activities that have to be carried out in order for businesses to avail completed goods to the customer. These include: buying of raw materials, hiring people to operate machine, packaging the finished product, delivery and receipt of payment. These activities are unavoidable since they are directly related to the conversion of raw materials into finished goods. The expenses undergone because of these activities are what are known as direct costs and include materials and labor (Crosson & Needles, 2011). Other activities such as administration, licensing and paying electricity bills results in additional costs that are not directly involved in the fulfillment of the contract.
There are many things that can go wrong during the analysis of direct costs. The first problem during this process is differentiating between direct costs and indirect costs. Personnel in the financial and accounts departments must be keen when categorizing the cost items in their books of accounts. It is important to identify the direct costs since these need to be given the first priority when acquisitions are being made. For instance, if the finance director fails to pay suppliers of raw materials in time thinking that they are usually patient people, this compromises timely delivery of materials leading to delays. Direct costs should be prioritized so that these are honored first to ensure that fulfillment of the contract is not compromised. Direct costs are sensitive to issues related to unit materials and every hour of labor that is required for production (Berends, 2004).
Another challenge that arises during analysis of direct costs is forecasting. Forecasting is required during the budgeting process which is done before the beginning of a financial year. Budgets are tools of control that are used to monitor the use of organizational resources. When the financial managers are budgeting, they need to take into account the costs that are likely to be incurred when purchasing materials and remunerating workers. In order to achieve this, historical information is required to provide estimates. Collection of this information becomes difficult if there are no clear and reliable records in the production and procurement departments. The financial director forecasts by collecting information about material and labor expenses for the past consecutive years. The data retrieved from this data can be used to determine trends of semi-variable, direct and indirect costs. The trends then help the manager to determine whether costs are likely to increase or decrease in the coming year.
Analysis of direct costs is important as they affect the profitability of a business. Increases in direct costs reduce the level of profitability. Therefore, it is crucial that a profitability sensitivity analysis is carried out so that it can be determined how direct costs may vary and the ones that affect profitability (Berends, 2004). The profitability sensitivity analysis enables the organization to determine the relationship that exists between the price of finished products, costs and profits. Since direct costs are affected by changes in material and labor, information about these variables should always e available. Technology should be used to organize, store and retrieve information about material and labor. The existence of computers, networking and the internet has made it easier for information management and they should be used to ensure that data is always kept safely.
References
Berends, W. (2004). $Price & profit%: the essential guide to product & service pricing and profit forecasting: developing your competitive pricing strategy: using performance-based contracts and performance incentives: the fundamentals of cost estimating and profit forecasting: valuable contract negotiation tools for buyers and sellers. Oakville, ON: Berends & Associates.
Crosson, S.V. & Needles, B.E. (2011). Managerial Accounting, Mason, OH: South-Western Cengage Learning.