1. Differentiate between direct costs and direct costing. See answer.

2. Distinguish between period costs and product costs. See answer

3. Why does the direct costing or variable costing theorist exclude fixed manufacturing
costs from inventories? See answer
4. In the process of determining a proper sales price, what kind of cost figures are
likely to be most helpful? See answer
5. Why is it said that an income statement prepared by the direct costing procedure is
more helpful to management than an income statement prepared by the absorption
costing method? See answer
6. Why should the chart of accounts be expanded when direct costing is used? See
answer
7. A manufacturing concern follows the practice of charging the cost of direct materials
and direct labor to work in process but charges off all indirect costs (factory
overhead) directly to income summary. State the effects of this procedure on the
concern's financial statements and comment on the acceptability of the procedure for
use in preparing financial statements. See answer
8. Has the Internal Revenue Service approved direct costing for tax purposes? See
answer
9. A speaker remarked that even though direct costing has attractive merits, there are
certain items that should be concerned before converting the present system. What
hidden dangers or disadvantages are present in direct costing? See answer
10. List the arguments for and against the use of direct costing. See answer
11. Select the answer which best completes the statement: See answer

(a) The term meaning that all manufacturing costs (direct and indirect, fixed and
variable) which contribute to the production of the product and traced to output and
inventories is: (1) job order costing; (2) process costing; (3) absorption costing; (4)
direct costing.
(b) The term that is most descriptive of the type of cost accounting often called direct
  costing is (1) out of pocket costing; (2) variable costing; (3) relevant costing; (4)
prime costing.
(c) Costs treated as product costs under direct costing are: (1) prime costs only; (2)
  variable production costs only; (3) all variable costs; (4) all variable and fixed
manufacturing costs.
(d) The basic assumptions made in direct costing with respect to fixed costs is that fixed
cost is: (1) controllable cost; (2) a product cost; (3) an irrelevant cost; (4) a period
cost
(e) Operating income computed using direct costing would generally exceed operating
income computed using absorption costing if: (1) units sold exceed units produced;
  (2) units sold are less than units produced; (3) units sold equal units produced; (4)
the unit fixed cost is zero
(f) A company has operating income of $50,000; using direct costing for a given period.
Beginning and ending inventories for that period were 13,000 units and 18,000
  units, respectively. If the fixed factory overhead application rate is $2 per unit, the
operating income using absorption costing is: (1) $40,000; (2) $50,000; (3)
$60,000; (4) not determinable from the information given.
(g) Absorption costing differs from direct costing in the: (1) fact that standard costs can
be used with absorption costing but not with direct costing; (2) kinds of activities for
which each can be used to report ; (3) amounts of costs assigned to individual units
of product; (4) amount of fixed costs that will be incurred.
(h) When a firm uses direct costing: (1) the cost of a unit of product changes because of
 changes in the number of units manufactured; (2) profits fluctuate with sales; (3) an
idle capacity variance is calculated by a direct costing system; (4) product cost
include variable administrative costs.
(i) Operating income under absorption costing can be reconciled to operating income
determined under direct costing by computing the difference between: (1)
inventoried fixed costs in the beginning and ending inventories and any deferred
  over or under applied fixed factory overhead; (2) inventoried discretionary costs in
the beginning and ending inventories; (3) gross profit (absorption costing method)
and contribution margin (direct costing method); (4) sales as recorded under the
direct costing method and sales as recorded under the absorption costing method.
(j) Under the direct costing concept, unit product cost would most likely be increased
by: (1) a decrease in the remaining useful life of factory machinery depreciated by
the units of production method; (2) a decrease in the number of units produced; (3)
an increase in the remaining useful life of factory machinery depreciated by the sum
of the years digits method; (4) an increase in the commission paid to salespersons
for each units sold.
(k) When using direct costing information, the contribution margin discloses the excess
of: (1) revenue over fixed cost; (2) projected revenue over the break even point;
  (3) revenue over variable cost; (4) variable cost over fixed cost.
See answers

Answers:
1. Direct costs are direct materials, direct labor, and other costs directly assignable to
a product. Direct costing or variable costing is a procedure by which only prime
costs plus variable factory overhead are assignable to a product or inventory; all
fixed costs are considered period costs.
2. Period costs are costs charged against the income of the current period. In direct
costing, the fixed factory overhead as well as selling and administrative expenses are
treated as period costs. Expenses that apply to the production of goods are called
product costs. Variable manufacturing costs are typical product costs in direct
costing and are charged against income when the units to which they relate are sold.
3. Fixed manufacturing costs are the expenses of maintaining capacity; such
expenses occur with the passage of time and not with the utilization of the facilities.
4. There is no way to prove that one type of cost figure is going to be more helpful than
another in the determination of the sales price. The sales price must exceed all costs
of every kind before a profit is realized, but this does not mean that some sales of a
single product or sales of products could not be made at a price which recovers at
least the variable costs or makes a contribution to the recovery of fixed expenses.
The absorption or conventional cost approach to pricing looks at the long run
total cost recovery. The marginal costing or direct costing approach looks at the
short run profit contribution aspect of immediate sales. It seems probable that direct
costing is more appropriate in making short run decisions with regard to production
schedules and pricing products offered for sales, provided the total cost recovery in
the long run is kept in mind.
5. An income statement prepared by the direct costing method presents cost of goods
sold figures with variable costs only. These variable costs, based on the number of
units sold, facilitate computing a contribution margin figure. Thus the direct costing
income statement is preferred by the management because it follows management's
decision making processes more closely that the statement based on absorption
costing.
6. Under a direct costing plan, all variable expenses are channeled into the fixed
category at the time the expenses are incurred. This procedure means that the chart
of accounts has to be expanded to take care of the new accounts needed.
7. The cost to manufacture usually includes the sum of direct materials, direct labor,
and applicable indirect factory costs. Consequently, by omitting indirect factory costs
from work in process (WIP) the concern is understanding inventory accounts in
comparison with concerns which follow the usual practice. At any particular time,
then, its financial position (balance sheet) is incorrectly stated because: (a) work in
process and finished goods are understated; (b) current assets are understated and
so is the net working capital--and therefore the current ratio is understated; (c) total
assets are under stated; (d) stockholder's equity is understated--particularly the
retained earnings amount.
Of at least equal importance is the effect on the recorded results of operations.
Unless the sum of the work in process and finished goods accounts happens to be
the same at each balance sheet date, costs and revenue will not be matched in the
usual manner, resulting in a corresponding distortion of reported income. Thus, if
these inventories at the end of the year exceed the corresponding totals at the
beginning of the year, Profits will be understated; if these inventories are below
those at the beginning of the year, profits will be overstated.
It is not accepted accounting practice to omit all factory overhead from inventories.
While the costs of idle facilities, excessive spoilage, and certain other variances and
usual items may be treated as period costs, the usual indirect costs are considered
assignable to the production of the period. These indirect factory costs are ordinarily
not as easily assignable to products as are the direct cost; but at the time they are
incurred, they are recoverable from future revenues. Therefore, they should be
added to the direct costs and flow through inventories.
8. The Internal Revenue Service (IRS) does not permit the use of direct costing for
tax purposes because it does not clearly reflect income.
9. The hidden dangers or disadvantages present in direct costing are:
(a) A change to direct costing will prohibit a comparison with the company's
accounting information for any prior year unless past periods are changed to a direct
costing basis.
(b) A seasonal business which produces for six months and sells its entire production
in the next six months would show a sizeable loss for the first six months and a
sizeable profit for the last six months.
(c) Those who use direct costing figures must understand the difference between
conventional gross profit on sales and contribution to fixed costs and profits and
realize the limitations of the contribution theory.
(d) In planning price and sales policies, the full cost to develop, produce, and
market a product must be known. Using direct costs and looking at marginal
contributions only would certainly be fallacious when new extensive use of existing
expensive equipment or expansion of facilities.
(e) Direct costing might bring unsatisfactory management action when sales outrun
production and inventories are being drawn on. Under these conditions, direct cost
profits are higher than under absorption costing. The opposite is true when sales lag
behind production.
(f) When used as the sole vehicle for the management decisions, direct costing can
lead to a disregard for the need to recover fixed costs.
10. Arguments for the use of direct costing include the following:
(a) For profit planning purposes, management requires cost volume profit
relationship data which are more readily available from direct cost statement than
from absorption costing.
 (b) Since fixed factory overhead is absorbed as a period cost, increasing or reducing
production and differences in the number of units produced versus the number sold
do not affect the per unit production cost.
(c) Direct costing reports are more easily understood by management because the
statements follow management's decision making process more closely than do
absorption costing statements.
(d) Reporting the total fixed cost for the period in the income statement directs
management's attention to the relationship of this cost to profits.
(e) The elimination of allocated joint fixed cost permits a more objective appraisal of
income contributions according to products, sales areas, kinds of customers, etc.
Cost volume relationships are highlighted.
(f) The similarity of the underlying concepts of direct costing, flexible budgets, break
even analysis, and standard costs facilitates the adoption and use of these methods
for reporting, cost control and financial planning.
(g) Direct costing provides a means of costing inventory that is similar to
management's concept of inventory cost as the current out of pocket expenditures
necessary to produce or replace the inventory.
(i) The computation of product costs is simpler and more reliable under direct
costing because a basis of allocating the fixed cost, which involves estimates and
personal judgment, is eliminated.
(j) A "true and proper" profit results from direct costing because only variable costs
should be identified with production. Fixed costs occur with the passage of time.
Arguments against the use of direct costing include the following:
(a) Separation of costs into fixed and variable costs might be difficult, especially
when such costs are semi variable in nature. Moreover, all costs--including fixed
costs--are variable at some level of production and in the long run.
(b) Long-range pricing of products and other long range policy decisions require a
knowledge of complete manufacturing cost which would require additional separate
computations to allocate fixed overhead.
(c) The pricing of inventories by the direct costing method is not acceptable for
income tax computation purposes.
(d) Direct costing has not been recognized as conforming with generally accepted
accounting principles (GAAP) applied in the preparation of financial statements for
stockholders and general public.
(e) Profits determined by direct costing are not "true and proper" because of the
exclusion of fixed production costs which are a part of total production costs. and
inventory. Production would not be possible without plant facilities, equipment, etc.
To disregard these fixed costs violates the general principle of matching costs with
revenues.
(f) The elimination of fixed costs from inventory results in a lower figure and
consequent reduction of reported working capital for financial analysis purposes. The
decrease in working capital may also weaken the borrowing position.
11. (a) 3; (b) 2; (c) 2; (d) 4; (e) 1; (f) 3*; (g) 3; (h) 2; (i) 1; (j) 1 (k) 3
*Operating income under direct costing + Cost deferred in inventory
$50,000 + $10,000
$60,000

You may also be interested in other relevant articles:

 Variable Costing Vs Absorption Costing

 Income Comparison of Variable and Absorption Costing
 Advantages of Variable Costing
 Variable costing and External Reports
 Variable Costing and Theory of Constraints
 Impact of Just In Time (JIT) Inventory Methods
 Advantages and Disadvantages of Absorption Costing
 Variable | Direct Costing and Absorption Costing Discussion Questions and Answers