Full costing is an accounting method used to determine the complete end-to-end cost of producing products or services.
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.
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.
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).
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.
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.
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.
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.
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.
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.
Another major flaw of full costing is that it can potentially mislead investors. Fixed costs are not deducted from revenues unless all of the company’s manufactured products are sold, meaning that a company’s profit level can appear better than it actually is during a given accounting period.
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.