the uses and limitations of the full costing method

5.4 Costs – Approaches to Costing

Objective

To understand the uses and limitations of the full (absorption) costing method and the contribution (variable) costing method, and to be able to select the appropriate approach for different business decisions and for external reporting.

1. Cost classifications – why accurate cost data matter

• Fixed costs: Do not vary with the level of output (e.g., factory rent, salaried supervisor’s salary).
• Variable costs: Vary directly with output (e.g., raw material, direct‑labour wages per unit).
• Direct costs: Can be traced directly to a single product or service (e.g., material used in a specific product).
• Indirect costs (overheads): Cannot be traced to a single product; they are allocated (e.g., factory lighting, depreciation of machinery).

Accurate cost information underpins:

• Pricing decisions – ensuring all relevant costs are covered.
• Budgeting and variance analysis – comparing expected and actual performance.
• Performance monitoring – measuring profitability of product lines or departments.
• External reporting – complying with IFRS, GAAP and Cambridge syllabus requirements.

2. Full (Absorption) Costing

2.1 Definition & formula

Full costing (also called absorption costing) assigns **all** manufacturing costs – both variable and fixed – to each unit of product.

Full cost per unit =

\[ \frac{\text{Total Variable Production Costs} \;+\; \text{Total Fixed Production Overheads}}{\text{Units Produced}} \]

2.2 Treatment of costs

• Production costs (variable + fixed) are absorbed by units produced.
• Fixed production overheads are allocated to units on a systematic base (e.g., machine‑hours, labour‑hours, number of units).
  Example: Fixed factory overhead = £20 000; allocation base = 10 000 machine‑hours → £2 per machine‑hour. If a product uses 5 mh, its share of overhead is £10.
• Selling and administrative expenses are period costs and are expensed in the period incurred (they are **not** absorbed into inventory).

2.3 Uses of full costing

1. Financial reporting – required by IFRS, GAAP and the Cambridge syllabus for external accounts and inventory valuation.
2. Inventory valuation – inventories on the balance sheet include a proportionate share of fixed overheads.
3. Long‑term pricing – provides a complete view of product cost, ensuring prices cover all manufacturing expenses.
4. Profitability analysis – enables calculation of gross profit by matching total production cost with revenue.
5. Budgeting & variance analysis – forms the basis of absorption‑cost budgets and overhead‑efficiency variance calculations.

2.4 Limitations of full costing

• Distorts cost behaviour – spreading fixed overheads over units can hide the true variable‑cost structure.
• Incentivises over‑production – higher output lowers unit cost, which may lead managers to produce more than market demand.
• Less useful for short‑term decisions – special‑order pricing, make‑or‑buy, or product‑line continuation are better served by contribution costing.
• Complex allocation – choosing an appropriate allocation base can be arbitrary and time‑consuming.
• Profit can be misleading – changes in inventory levels affect reported profit even when sales are unchanged.

2.5 When to use full costing

• Preparing statutory accounts and filing tax returns.
• Valuing inventory for balance‑sheet presentation.
• Setting long‑term pricing strategies where covering all production costs is essential.
• Developing absorption‑cost budgets and analysing overhead variances.

3. Contribution (Variable) Costing

3.1 Definition & formula

Contribution costing allocates only **variable** manufacturing costs to units. All fixed production overheads are treated as period costs and are charged to the income statement in the period incurred.

Contribution per unit =

\[ \text{Selling price per unit} \;-\; \text{Variable cost per unit} \]

3.2 Treatment of costs

• Variable production costs (direct material, direct labour, variable overhead) are absorbed by units.
• Fixed production overheads are expensed in full each period – they do **not** form part of inventory cost.
• Selling & administrative expenses remain period costs, as in full costing.

3.3 Uses of contribution costing

1. Short‑term pricing decisions – e.g., evaluating a special order that does not affect fixed costs.
2. Break‑even and margin‑of‑safety analysis – the contribution margin is the key input.
3. Product‑line, make‑or‑buy and discontinue decisions – isolates the incremental cost of producing an additional unit.
4. Performance measurement – contribution‑margin ratios highlight how efficiently each product generates profit.

3.4 Limitations of contribution costing

• Not acceptable for external financial statements – it would understate the cost of inventory on the balance sheet.
• Can give a lower product cost than full costing, potentially leading to under‑pricing if used alone.
• Requires a reliable separation of variable and fixed costs, which may be difficult in practice (especially for semi‑variable costs).
• Does not provide a complete picture of total product cost for long‑term strategic decisions.

3.5 When to complement full costing with contribution costing

• When making short‑term decisions such as accepting a one‑off order below normal selling price.
• When analysing the profitability of individual products or services without the distortion of allocated fixed overhead.
• When preparing internal management reports, contribution statements, and break‑even forecasts.

4. Comparison of Full (Absorption) and Contribution (Variable) Costing

Aspect	Full (Absorption) Costing	Contribution (Variable) Costing
Cost allocation	All manufacturing costs (variable + fixed) are allocated to units.	Only variable manufacturing costs are allocated to units; fixed overheads are period costs.
Treatment of selling & admin expenses	Period costs – expensed in the period incurred.	Period costs – expensed in the period incurred.
Compliance with external reporting standards	Required by IFRS, GAAP and Cambridge syllabus for inventory valuation.	Not permitted for external financial statements.
Impact of production volume on unit cost	Higher production spreads fixed overhead, lowering unit cost.	Unit cost remains unchanged; fixed overhead does not affect unit cost.
Effect of inventory changes on reported profit	Profit rises when production exceeds sales (inventory builds up) because some fixed overhead is deferred in inventory.	Profit is unaffected by inventory levels – fixed overhead is charged in full each period.
Decision‑making suitability	Less suitable for short‑term decisions; best for external reporting and long‑term pricing.	Ideal for pricing, product‑mix, make‑or‑buy, and break‑even analysis.
Profit calculation	Profit = Sales – (Variable + Fixed production costs) – Period costs.	Contribution = Sales – Variable costs; Profit = Contribution – Fixed production overheads – Period costs.
Use in budgeting & variance analysis	Forms the basis of absorption‑cost budgets; enables overhead‑efficiency variance analysis.	Provides the contribution margin needed for break‑even and margin‑of‑safety calculations.

5. Difference between Contribution and Profit

• Contribution = Sales – Variable Costs. It shows the amount available to cover fixed costs and generate profit.
• Profit = Contribution – Fixed Production Overheads – Fixed Period Costs.
• In a contribution statement the flow is:
  Sales → Variable Costs → Contribution → Fixed Production Overheads → Fixed Period Costs → Profit.

6. Numerical examples

Example 1 – Production equals sales (balanced output)

Assume for a month:

• Units produced = Units sold = 5 000
• Direct material (variable) = £4 per unit
• Direct labour (variable) = £3 per unit
• Variable factory overhead = £1 per unit
• Fixed factory overhead = £20 000
• Selling price = £12 per unit

Full costing unit cost:

\[ \frac{(4+3+1)\times5\,000 \;+\; 20\,000}{5\,000}= \frac{40\,000+20\,000}{5\,000}= £12 \text{ per unit} \]

Contribution per unit:

\[ 12 - (4+3+1)= £4 \text{ per unit} \]

If all 5 000 units are sold:

• Profit (full costing) = £0 (sales £60 000 – total absorbed cost £60 000).
• Profit (contribution costing) = Contribution (£4 × 5 000 = £20 000) – Fixed overhead (£20 000) = £0.

Example 2 – Over‑production creates inventory

Same cost data as Example 1, but the company produces 6 000 units and sells only 5 000.

Full costing

• Full cost per unit = £12 (as above).
• Cost of goods sold = 5 000 × £12 = £60 000.
• Closing inventory (1 000 units) = 1 000 × £12 = £12 000 (still carries £12 000 of fixed overhead on the balance sheet).
• Profit = Sales (£12 × 5 000 = £60 000) – COGS (£60 000) = £0.

Contribution costing

• Variable cost per unit = £8; contribution per unit = £4.
• Contribution from sales = 5 000 × £4 = £20 000.
• Fixed overhead (expensed in full) = £20 000.
• Profit = £20 000 – £20 000 = £0.

**Key observation** – because the fixed overhead of £20 000 is fully absorbed into the 6 000 units, the unit cost (£12) is lower than the selling price, creating an apparent profit if only 5 000 are sold. In reality the profit is neutral; the “extra” £12 000 of overhead remains in inventory under full costing, whereas contribution costing shows the same result without inventory distortion.

7. Linkage to other syllabus areas

• 5.4.4 Break‑even analysis – the contribution margin per unit derived from contribution costing is the denominator in the break‑even formula: Break‑even volume = Fixed Costs ÷ Contribution per unit.
• 5.5 Budgets – absorption‑costing provides the basis for the production budget and the overhead‑efficiency variance, while contribution costing supplies the data needed for the profit‑budget and the cash‑budget (through the contribution margin).
• Decision‑making techniques – make‑or‑buy, special‑order and product‑line continuation decisions all require the variable‑cost information supplied by contribution costing.

8. Summary

Full (absorption) costing is essential for external reporting, inventory valuation and long‑term pricing because it includes **all** manufacturing costs. However, it can mask cost behaviour, encourage over‑production and give profit figures that are sensitive to changes in inventory levels.

Contribution (variable) costing isolates the effect of variable costs, providing a clear contribution margin that is indispensable for short‑term managerial decisions, break‑even analysis and performance measurement. It cannot be used for external financial statements, but when combined with full costing it gives managers a complete picture of both total product cost and the incremental cost of additional output.

Effective managers therefore understand both methods, recognise their respective strengths and weaknesses, and apply them together to support accurate reporting, sound budgeting, and informed decision‑making.