What Is Full Costing (Absorption Costing)?
Full costing—also called full costs or absorption costing—is an accounting method that assigns all manufacturing costs to products: direct costs, variable overhead, and fixed manufacturing overhead. Under this approach, costs follow the product through inventory accounts and are only recognized as expenses (cost of goods sold, COGS) when the product is sold. Full costing is required for external financial statements under GAAP and IFRS and for tax reporting in most jurisdictions. (Source: Investopedia)
Key takeaways
– Full costing includes direct costs and both variable and fixed manufacturing overhead in unit product cost.
– Fixed manufacturing overhead is capitalized in inventory and expensed when goods are sold.
– It is required for external financial reporting (GAAP/IFRS) and tax filings.
– Variable (direct) costing treats fixed manufacturing overhead as a period expense—this produces different profit behavior.
– Full costing can affect profit comparability, CVP analysis, and managerial decision making when inventories change.
How full costing works — the concept and flow
1. Identify all manufacturing costs:
– Direct materials (DM)
– Direct labor (DL)
– Manufacturing overhead (MOH), split into:
– Variable MOH (utilities per machine hour, indirect materials)
– Fixed MOH (depreciation, plant rent, salaried supervisors)
2. Assign direct costs to specific products.
3. Allocate overhead to products using a chosen allocation base (machine hours, labor hours, direct labor dollars, etc.) and an overhead rate.
4. Capitalize total unit cost (DM + DL + allocated MOH) into Inventory (Raw Materials → WIP → Finished Goods).
5. When units are sold, move the related unit cost from Finished Goods to COGS on the income statement.
Core formulas
– Predetermined overhead rate = Budgeted total MOH / Budgeted allocation base (e.g., machine hours).
– Unit product cost = Direct materials + Direct labor + Variable MOH per unit + Allocated fixed MOH per unit.
– COGS (for units sold) = Units sold × Unit product cost.
Simple numeric example
Assume in a period:
– Produced 1,000 units.
– Direct materials per unit = $10
– Direct labor per unit = $5
– Variable MOH per unit = $2
– Total fixed MOH for period = $10,000
Allocated fixed MOH per unit = $10,000 / 1,000 = $10
Unit full cost = 10 + 5 + 2 + 10 = $27
If the company sells 700 units this period:
– COGS = 700 × $27 = $18,900
– Ending finished goods inventory = 300 × $27 = $8,100
Note how $3,000 of fixed MOH (300 units × $10) remains capitalized in inventory and is not expensed until those units are sold. If production had been 1,000 but sales 1,000, all fixed MOH would be expensed.
Full costing vs. variable (direct) costing — main differences
– Treatment of fixed manufacturing overhead:
– Full costing: allocated to units; capitalized and expensed with COGS.
– Variable costing: treated as a period expense; deducted in the period incurred.
– Reported profit:
– Full costing: profit can increase if production larger than sales (because some fixed costs are deferred in inventory).
– Variable costing: profit reflects period fixed costs immediately—inventory levels do not affect period profit with respect to fixed MOH.
– External reporting:
– Full costing is required by GAAP/IFRS for external financial reports; variable costing is used only for internal decision making.
Advantages of full costing
– Compliance: Meets GAAP/IFRS and tax reporting requirements.
– Complete product cost: Shows the total cost to produce a unit, useful for long-term pricing and profitability analysis.
– Profit smoothing when inventory varies: If production exceeds sales, some fixed costs are deferred to inventory, which can stabilize reported profit across fluctuations in demand.
– Useful when fixed costs are a significant portion of manufacturing cost.
Disadvantages and risks
– Comparability issues: Full costing can make performance comparisons between products or periods harder because fixed costs may be allocated arbitrarily.
– Can mask inefficiencies: Capitalizing fixed MOH hides some fixed-cost effects on profitability until goods are sold.
– Distorts CVP analysis: When fixed costs represent a large portion of production cost, it becomes harder to use full costing directly for short-term break-even and margin analysis.
– Potential to inflate profit: If a company increases production primarily to defer fixed costs into inventory, reported profit may look better even if cash or economic performance hasn’t improved.
Practical steps to implement full costing (for accounting/operations teams)
1. Define and classify costs
– Compile all production-related costs and classify them as direct vs. indirect, variable vs. fixed.
2. Choose an allocation base for overhead
– Common bases: direct labor hours, direct labor dollars, machine hours, or activity-based drivers.
– Select a base that best correlates with how overhead is consumed.
3. Estimate budgeted totals
– Prepare budgeted (or standard) totals for MOH and the allocation base for the period to compute a predetermined overhead rate.
4. Compute predetermined overhead rate
– Predetermined MOH rate = Budgeted MOH / Budgeted allocation base.
5. Apply overhead to production
– For each job or production batch, allocate overhead = Predetermined rate × actual allocation base used.
6. Track and record costs through inventory accounts
– Record DM and DL into Work in Process (WIP), apply MOH to WIP, transfer completed units to Finished Goods, and record COGS as units sell.
7. Reconcile and adjust
– At period end reconcile applied overhead to actual overhead. Record any under- or overapplied MOH (adjust COGS or prorate to inventory/COGS per policy).
8. Review for management use
– Produce internal reports using variable costing as well, if desired, for managerial decisions and CVP analysis.
9. Document policies
– Maintain clear accounting policies for overhead allocation and inventory valuation to ensure consistent external reporting.
Typical journal entries (simplified)
– Record direct materials used:
Dr WIP Inventory
Cr Raw Materials Inventory
– Record direct labor:
Dr WIP Inventory
Cr Wages Payable (or Cash)
– Apply MOH to WIP:
Dr WIP Inventory
Cr Manufacturing Overhead Applied
– Move completed goods:
Dr Finished Goods Inventory
Cr WIP Inventory
– When goods are sold:
Dr Cost of Goods Sold
Cr Finished Goods Inventory
Month-end MOH reconciliation
– If actual MOH > applied MOH: record underapplied MOH (debit COGS or prorate to inventory).
– If actual MOH < applied MOH: record overapplied MOH (credit COGS or prorate).
Managerial tips and caveats
– Use both full costing and variable costing: For external compliance use full costing; for short-term decisions, throughput analysis, and pricing promotions consider variable costing to see the impact of fixed costs separately.
– Avoid production-volume tricks: Increasing production solely to push fixed costs into inventory can temporarily inflate profits—management should focus on economic performance, cash flow, and inventory turnover.
– Consider activity-based costing (ABC) for better allocation: If overhead is complex, ABC can allocate overhead more accurately than a single broad base.
– JIT and lean operations: As companies adopt just-in-time production and reduce inventory, the differences between full and variable costing become less significant because less fixed cost is carried in inventory.
When to use full costing
– External financial reporting and tax returns (required).
– Long-term pricing, product line profitability that needs total cost coverage.
– Industries with significant fixed manufacturing overhead where capitalizing those costs to inventory gives a truer long-term product cost.
Conclusion
Full (absorption) costing is the standard accounting method for recording and reporting the complete cost of production, required by GAAP/IFRS and tax authorities. It provides a comprehensive per-unit cost by including fixed manufacturing overhead in inventory until units are sold. While useful for external reporting and long-term pricing, full costing can complicate managerial analysis and obscure short-term cost behavior—so many companies use variable costing internally alongside absorption costing for decision support.
Source
– Investopedia, “Full Costing (Absorption Costing)”: https://www.investopedia.com/terms/f/full-costing.asp
If you’d like, I can:
– Provide a spreadsheet-ready example showing production, allocation, and the impact on COGS and inventory, or
– Create a short checklist your accounting team can use to implement full costing in your ERP system. Which would you prefer?