If a firm produces a range of products, one accounting issue is how it deals with its fixed/indirect costs, such as rent and interest. This is a subject dealt with in greater detail in the operations and management pack.
Absorption cost and full cost pricing are methods used to allocate all the indirect/fixed costs when determining the price.
- Full cost pricing is simple, because the same formula is used to allocate all the costs to each of the product. The full-cost pricing formula may, for instance, be based on the area of the factory used to create each product.
- Absorption pricing is a more sophisticated variant on this where costs are allocated more precisely. Each indirect cost will be treated separately and allocated accordingly.
Advantages and disadvantages of absorption/full cost pricing
Advantages
- It recognises the importance of indirect costs as an element of overall cost
- It allows for more accurate and precise apportionment of costs
- It offers a more flexible pricing approach than other cost-based pricing approaches
Disadvantages
- It may appear to offer an accurate approach, but in some instances it can be difficult to calculate an accurate apportionment of costs
- If used in isolation it may focus too much on product and costs and not be sufficiently flexible to take into account changes in demand and customer needs
What Is Full Costing?
Full costing is an accounting method used to determine the complete end-to-end cost of producing products or services.
Key Takeaways
- Full costing, or absorption costing, accounts for all costs, both fixed and variable along with overhead, that go into a finished product.
- Advantages of full costing include compliance with reporting rules and greater transparency.
- Drawbacks include potential skewed profitability in financial statements and difficulties determining variations in costs at different production levels.
Understanding Full Costing
Also known as "full costs" or "absorption costing,” it is required in most common accounting methodologies, including generally accepted accounting principles [GAAP], International Financial Reporting Standards [IFRS], and reporting standards for income tax purposes.
When using the full costing method, all direct, fixed, and variable overhead costs are assigned to the end product.
- Direct costs: are expenses directly related to the manufacturing process. They can include staff wages, the costs of any raw materials used, and any overhead expenses, such as batteries to run machinery.
- Fixed costs: are primarily overhead expenses, such as salaries and building leases, that remain the same, regardless of how much or how little the company is selling. A company must pay its office rent and wages every month, even if it manufactures nothing.
- Variable overhead costs: are the indirect expenses of operating a business that fluctuates with manufacturing activity. For example, when output rises additional staff may be hired to help out. This scenario would result in the company stomaching higher variable overhead costs.
In full costing accounting, these various expenses move with the product [or service] through inventory accounts until the product is sold. The income statement will then recognize these as expenses under costs of goods sold [COGS].
Full Costing Vs. Variable Costing
The alternative to the full costing method is known as variable or direct costing. The treatment of fixed manufacturing overhead costs, such as salaries and building leases, is the primary difference between these two different accounting styles.
Companies that use variable costing separate these operating expenses from production costs. In short, they seek to establish the expenses incurred during the manufacturing process, independent of the everyday costs of running a business.
Under the variable costing method, fixed manufacturing overhead costs are expensed during the period they are incurred. In contrast, the full costing approach recognizes fixed manufacturing overhead costs as an expense when goods or services are sold. Choosing one method over another can have sizable effects on the reporting of financial statements.
In practice, neither costing method is right or wrong. Some organizations will find variable costing more effective, while others will prefer full costing. The usefulness of method selection boils down to managerial attitude, behavior, and organizational design as it relates to accurate input cost capture and valuation.
As more businesses move to just-in-time [JIT] or related streamlined production procedures and inventory systems, in many ways, direct or full costing methods lose their significance, because fewer costs and expenses are tied up in production processes.
Advantages of Full Costing
Compliant With Reporting Rules: One of the biggest benefits of full costing is that it complies with GAAP. Even if a company decides to use variable costing in-house, it is required by law to use full costing in any external financial statements it publishes. Full costing is also the method that a company is required to use for calculating and filing its taxes.
Accounts for All Production Costs: Factoring in all expenses provides investors and management with a complete picture of how much it costs a company to manufacture its products. Establishing the total cost per unit helps businesses to determine suitable pricing for goods and services.
Easier to Track Profits: Full costing presents a more accurate idea of profitability than variable costing if all of the products are not sold during the same accounting period when they are manufactured. This can be especially important for a company that ramps up production well in advance of an anticipated seasonal increase in sales.
Disadvantages of Full Costing
Difficult to Compare Product Lines: Full costing also has several drawbacks. For example, taking into account all expenses, including those not directly associated with production, may make it slightly harder for management to compare the profitability of different product lines.
Impacts Efforts to Improve Operational Efficiency: Management teams using full costing will also find it more challenging to run cost-volume-profit [CVP] analysis, which is used to determine how many products a company must manufacture and sell to reach the point of profitability, and improve operational efficiency. If fixed costs are an especially large part of total production costs, it is difficult to determine variations in costs that occur at different production levels.