Think Direct Margin over Cost Accounting

It’s December 1990. A young business major sits on a cold stone bench outside the stately doors of his university’s business school building. Only moments prior, he completed one of the toughest final exams of his academic career; one he most certainly failed. Devastated and utterly defeated, he lacks the energy to do anything but consider his impending academic doom. Elbows balanced just above his knees, forehead buried in the palms of his hands, he mutters, “Cost accounting makes no sense.”

This young man is not alone in his conclusion. Brilliant accounting students at the finest universities in the world struggle to understand the concepts of cost accounting. Why? Because it doesn’t make sense. Maybe it does to the bean counters who have studied its concepts for years, but to everyone else, it is totally unintuitive.

The young man described in the opening paragraph did in fact end up graduating. In spite of his challenges with cost accounting, he earned a CPA license, and though my attitude toward much has changed in the quarter century hence, my opinion about cost accounting has not. Not that it’s illogical. I get it now. I can review a cost accounting-based income statement and understand it. But cost accounting is confusing, is of little value in making business decisions and can in fact lead to poor ones.

So if cost accounting doesn’t make sense to a CPA with a business degree, how will it ever be sensible to the valuable team on the shop floor who make the difference between winning and losing? 

More than a decade ago, a mentor introduced me to another way, a better way, a much simpler and understandable way of tracking manufacturing performance: direct margin.

The direct margin model subtracts truly direct costs from revenue to arrive at direct margin. No burden, no complicated allocations, no driving up our pricing models in an effort to absorb a bunch of overhead. Just revenue minus direct costs.

Direct costs include labor directly attributable to machining, steel or other raw materials consumed in the machining process, cutting fluids, and any other costs directly related to manufacturing.

Everything else goes below the direct margin line. Let the accountants worry about allocating supervision, office electricity, sales commissions, equipment depreciation and so on: Just give the manufacturing team a snapshot of its true productivity.

It’s not complicated, though expect the accountants to double over in distress.

“No,” they will argue. “Expenses, like our salaries, those of the customer service team and property taxes, are true costs, and somebody has to pay for them.”

No you don’t. Those costs are not variable in their relationship to sales volume. In the short term, we are stuck with the fixed salaries and expenses we have. 

“But what about capital equipment and fixed cost additions,” they will protest. “We need to burden the product cost with our complex depreciation models.”

No you don’t. In my direct costing model, decisions about adding equipment or fixed costs are made based on the answers to two questions: Will what happens if we don’t incur the cost be good or bad for the business? And, if we make the expenditure, when will the additional direct margin (resulting from additional revenue or reduced direct cost) pay back and can we live with that period of time? 

Direct margin as a percentage of sales will appear high, 70 percent or more in many companies, compared with a traditional and highly burdened gross profit model, and this takes some getting used to. 

However, once team members get accustomed to measuring the business using direct margin, the benefits are many. Financial performance can be easily explained to any employee (not only the accountants). Product pricing decisions can be made by determining the maximum the market will bear and comparing that with the minimum direct margin percentage we are willing to accept.

Leave the complicated allocations to the accountants. For the rest of us, direct margin accounting is easy to understand, is a great tool for making decisions and doesn’t tie my stomach in knots.