Accounting involves calculating the costs of manufacturing or producing the products and services of a business. Using this information, the business can then determine the appropriate sales strategy. Direct margin refers to the profit a business earns for a product or service. Knowing the direct margin can help business managers make more accurate pricing decisions.
A direct cost is an expense that you can easily identify as arising from a certain activity, project, product or service. Direct costs may be due to direct materials or direct labor. Direct materials become part of the finished product and direct labor goes into manufacturing the product or service. For example, the direct materials that go into a can of soda include the can, the label, syrup, water and other ingredients. Direct labor includes the wages of the factory workers who operate the machines that produce the soda.
The direct margin is the difference between the sales price of the product or service and the direct costs. For example, if a can of soda requires direct costs of $1 to produce and it sells for $2, then its direct margin would be $1. You can also express the direct margin as a percentage, which would be 50 percent in this example. Direct margin does not take into account indirect costs, such as renting a factory building or utilities.
Determining the Break-Even Point
A business can use the direct margin of a product or service to make pricing decisions. To calculate the break-even volume of a product or service, an account will use the following formula: (fixed costs / direct cost margin percentage) / selling price. Fixed costs refer to costs that don't change over time, including rent and the salary of administrative employees. If the business sells at least the break-even volume, it will cover the direct costs of manufacturing the products or services.
The highest direct margin does not always lead to the highest profits. This is because higher prices lead to lower demand, so the business may end up selling fewer products. For example, if a business sells 50,000 products with a direct margin of $1 each, it will earn a profit of $50,000. If it sets the price at $10 instead, it may only sell 5,000 products, resulting in a profit of $50,000. At $4 per product, however, the business may sell 25,000 products and earn $100,000 in profits.