the differences between full costing and contribution costing

5.4 Costs – Approaches to Costing

Objective

By the end of this section you should be able to:

• Define full costing (absorption costing) and contribution costing (marginal costing) (5.4.1).
• Calculate unit costs, contribution margins and profit for each method (5.4.2).
• Identify the advantages, disadvantages, limitations and appropriate uses of each approach (5.4.3).
• Link costing decisions to pricing, break‑even analysis, external reporting and other Cambridge Business topics.

1. Syllabus Context

This topic belongs to the AS‑Level unit 5 Costs – Approaches to Costing. It underpins later A‑Level extensions such as investment appraisal (topic 10) and strategic decision‑making (topics 6‑9). The table shows how 5.4 fits into the whole syllabus and where you will need to refer back to it.

AS‑Level Topic	Key Sub‑topics	Link to 5.4 Costs
1 Business Activity	Business objectives, stakeholders, external influences	Costing informs pricing decisions that support profit‑maximising objectives.
2 People in Business	Motivation, training, labour costs	Variable labour costs are a component of contribution costing.
3 Marketing	Market research, product mix, pricing	Contribution margin helps decide which products to promote.
4 Operations Management	Production methods, capacity utilisation	Full costing allocates fixed overhead to units produced – relevant to capacity decisions.
5 Costs – Approaches to Costing	5.1 Cost classification, 5.2 Cost behaviour, 5.3 Cost‑volume‑profit, 5.4 Full vs contribution costing	Core focus of this note.
6 External Influences (A‑Level)	PEST, Porter’s Five Forces	External pressure may change fixed overhead, affecting full costing.
7 Business Strategy (A‑Level)	SWOT, strategic options	Contribution analysis supports strategic product‑mix decisions.
8 Organisational Structure (A‑Level)	Centralised vs decentralised costing systems	Choice of costing method influences responsibility accounting.
9 Marketing Strategy (A‑Level)	Pricing, promotion, distribution	Contribution margin is a key input for short‑term pricing.
10 Investment Appraisal (A‑Level)	NPV, IRR, pay‑back	Cash‑flow forecasts often use contribution figures rather than absorption costs.

2. Full Costing (Absorption Costing) – 5.4.1

2.1 Definition

Full costing allocates **all manufacturing costs – both fixed and variable – to each unit of product**. The unit cost therefore comprises:

• Direct materials
• Direct labour
• Variable manufacturing overhead
• Fixed manufacturing overhead (allocated on a per‑unit basis)

2.2 Formulae & Assumptions (5.4.2)

Assumptions: figures refer to a single accounting period; fixed overhead is spread evenly over the units produced in that period.

\[ \text{Total Cost per Unit} = \frac{\text{Fixed Manufacturing Overhead}}{\text{Units Produced}} + \text{Variable Cost per Unit} \] \[ \text{Profit per Unit} = \text{Selling Price per Unit} - \text{Total Cost per Unit} \]

2.3 Regulatory Requirement

Full costing is mandated by most accounting standards (IAS 2, IFRS, UK GAAP) for external financial statements because it ensures that inventory on the balance sheet includes a share of fixed production overhead.

2.4 Advantages, Disadvantages, Limitations (5.4.3)

• Advantages
  • Meets statutory requirements for external reporting.
  • Shows the total cost of producing a product – useful for long‑term pricing and cost‑recovery analysis.
  • Fixed overhead is eventually recovered through sales, giving a complete picture of profitability over time.
• Disadvantages
  • Profit can be distorted by changes in inventory levels – producing more than is sold may inflate profit.
  • Fixed costs are “hidden” in unit cost, making short‑term decisions less transparent.
  • Allocation of fixed overhead can be arbitrary and complex.
• Limitations
  • Not suitable for analysing the effect of a single additional sale because fixed overhead does not change with output.
  • May under‑state the incremental cost of a special order where fixed costs are already incurred.

2.5 When Full Costing Is Not Appropriate

• Short‑term pricing decisions where the focus is on the cost of an extra unit.
• Make‑or‑buy analysis where only variable costs differ between alternatives.
• Break‑even or margin‑of‑safety calculations that require a clear separation of fixed and variable costs.

3. Contribution Costing (Marginal Costing) – 5.4.1

3.1 Definition

Contribution costing treats **only variable costs** as product costs. Fixed costs are regarded as period costs and are expensed in the period incurred.

3.2 Key Measures (5.4.2)

\[ \text{Contribution Margin} = \text{Sales Revenue} - \text{Variable Costs} \] \[ \text{Contribution per Unit} = \text{Selling Price per Unit} - \text{Variable Cost per Unit} \] \[ \text{Profit} = \text{Total Contribution} - \text{Total Fixed Costs} \]

3.3 Advantages, Disadvantages, Limitations (5.4.3)

• Advantages
  • Clearly separates the effect of variable costs from fixed costs – ideal for marginal analysis.
  • Profit is independent of inventory levels, simplifying break‑even and CVP work.
  • Simple to compute; useful for rapid internal decision‑making.
• Disadvantages
  • Not acceptable for external financial statements – non‑compliant with IAS/IFRS.
  • Ignores the fact that fixed overhead must eventually be covered, which can mislead long‑term pricing.
  • Can under‑state the total cost of a product when fixed overhead is a large proportion of total cost.
• Limitations
  • Provides no information on the total cost of inventory held on the balance sheet.
  • May give a misleading picture of profitability if fixed costs are high and sales volumes fall.

3.4 When Contribution Costing Is Not Appropriate

• Preparation of statutory accounts or any external reporting requirement.
• Long‑term pricing where the full cost (including fixed overhead) must be recovered.
• Situations where inventory valuation is required for balance‑sheet presentation.

4. Comparison of Full Costing and Contribution Costing

Aspect	Full (Absorption) Costing	Contribution (Marginal) Costing
Cost allocation	All manufacturing costs (fixed + variable) allocated to units	Only variable manufacturing costs allocated; fixed costs treated as period costs
Profit measurement	Gross profit = Sales – (Variable + Allocated Fixed)	Contribution margin = Sales – Variable; profit = Contribution – Fixed
Decision‑making focus	Long‑term pricing, inventory valuation, external reporting	Short‑term decisions: pricing, product mix, make‑or‑buy, break‑even analysis
Impact of inventory changes	Profit can be affected because fixed overhead is absorbed into inventory	Profit is unaffected; fixed costs are expensed regardless of production volume
Regulatory acceptance	Required for external financial statements (IAS/IFRS)	Used only for internal management reporting
Typical users	External accountants, auditors, senior management (financial reporting)	Management accountants, product managers, operational planners

5. Numerical Examples (5.4.2)

5.1 Example 1 – All output sold (baseline)

Data for a single product:

• Selling price per unit: $50
• Direct material per unit: $12
• Direct labour per unit: $8
• Variable overhead per unit: $5
• Fixed manufacturing overhead (total): $30 000
• Units produced (and sold): 5 000

Full costing

1. Fixed overhead per unit = 30 000 ÷ 5 000 = $6
2. Total cost per unit = 12 + 8 + 5 + 6 = $31
3. Profit per unit = 50 – 31 = $19
4. Total profit = 19 × 5 000 = $95 000

Contribution costing

1. Variable cost per unit = 12 + 8 + 5 = $25
2. Contribution per unit = 50 – 25 = $25
3. Total contribution = 25 × 5 000 = $125 000
4. Profit = 125 000 – 30 000 (fixed) = $95 000

Both methods give the same profit because every unit produced is sold.

5.2 Example 2 – Unsold inventory (illustrates inventory effect)

Same cost data as Example 1, but only 4 000 of the 5 000 units produced are sold.

Full costing

1. Fixed overhead per unit remains $6 (allocated on production).
2. Total cost per unit = $31 (as above).
3. Cost of goods sold (4 000 × 31) = $124 000.
4. Closing inventory (1 000 × 31) = $31 000 (still on the balance sheet).
5. Profit = Sales (4 000 × 50 = $200 000) – COGS $124 000 = $76 000.

Contribution costing

1. Variable cost per unit = $25.
2. Total contribution = 4 000 × (50 – 25) = $100 000.
3. Profit = Contribution $100 000 – Fixed overhead $30 000 = $70 000.

Observation: With unsold inventory, full costing shows a higher profit ($76 000) than contribution costing ($70 000) because part of the fixed overhead is still capitalised in inventory. This difference is a key exam topic.

6. Pricing & Break‑Even Links (5.4.3)

• Pricing (long‑term): Full costing provides the total unit cost that must be covered to avoid losses over the product’s life‑cycle. Managers often add a markup to the absorption cost to set a sustainable selling price.
• Pricing (short‑term): Contribution margin per unit tells the lowest price at which a special order will not reduce profit – the price can be set at selling price = variable cost + desired contribution.
• Break‑Even Analysis: Uses the formula
  \[ \text{Break‑Even Volume} = \frac{\text{Total Fixed Costs}}{\text{Contribution per Unit}} \] – the contribution figure comes directly from marginal costing. Full costing is not used for break‑even because fixed overhead is already embedded in the unit cost.

7. When to Use Each Approach

7.1 Full (Absorption) Costing – appropriate uses

• Preparation of statutory accounts (IAS 2, IFRS, UK GAAP).
• Long‑term pricing and product‑line profitability analysis.
• Valuation of inventory on the balance sheet.
• Performance measurement of production efficiency over several periods.

7.2 Full Costing – situations where it is not appropriate

• Short‑term pricing or special‑order decisions.
• Make‑or‑buy analysis where only variable costs differ.
• Break‑even, margin‑of‑safety or CVP analysis.

7.3 Contribution (Marginal) Costing – appropriate uses

• Short‑term decisions: pricing, product mix, make‑or‑buy, special orders.
• Break‑even, margin of safety and CVP analysis.
• Assessing the impact of changes in sales volume on profit.
• Internal budgeting and responsibility accounting where fixed costs are treated as period costs.

7.4 Contribution Costing – situations where it is not appropriate

• External financial reporting or any statutory filing.
• Long‑term pricing that must recover all production costs.
• Inventory valuation for balance‑sheet presentation.

8. Cross‑Topic Link‑In Boxes

9. A‑Level Extensions (Brief Overview)

At A‑Level the same costing concepts appear in more complex contexts:

• External Influences (Topic 6) – PEST analysis may identify regulatory changes that increase fixed overhead, affecting absorption costing.
• Business Strategy (Topic 7) – Porter’s Five Forces can be combined with contribution margins to assess competitive advantage.
• Organisational Structure (Topic 8) – Decentralised divisions often use contribution costing for performance measurement.
• Marketing Strategy (Topic 9) – Pricing decisions use contribution data for short‑run promotions, while full costing underpins long‑run price setting.
• Investment Appraisal (Topic 10) – Cash‑flow forecasts for NPV or IRR calculations typically start from contribution figures rather than absorption costs.

10. Summary Checklist

• Full costing = all manufacturing costs (fixed + variable) allocated to units (5.4.1).
• Contribution costing = only variable manufacturing costs allocated; fixed costs are period expenses (5.4.1).
• Profit under full costing = Sales – (Variable + Allocated Fixed).
  Profit under contribution = Sales – Variable – Fixed (period) (5.4.2).
• Full costing required for external reports; contribution costing ideal for internal, short‑term decisions (5.4.3).
• Changes in inventory affect profit under full costing but not under contribution costing – remember for exam questions.
• Use the break‑even formula (Fixed ÷ Contribution per unit) when working with marginal costing.