Full costing, also known as absorption costing, is an accounting method that assigns all direct and indirect costs associated with the production of a product or service to the final cost of that product or service. This contrasts with variable costing, which only includes direct and variable indirect costs in the product cost.
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Full costing includes both variable and fixed costs in the product cost, whereas variable costing only includes variable costs.
Full costing provides a more comprehensive view of the total cost of producing a product or service, which is useful for pricing decisions and profitability analysis.
Under full costing, fixed overhead costs are allocated to products based on a predetermined overhead rate, typically using a cost driver such as direct labor hours or machine hours.
Full costing can result in higher reported product costs compared to variable costing, which can impact inventory valuation and net income.
The choice between full costing and variable costing can affect management decision-making, such as make-or-buy decisions, product mix, and pricing strategies.
Review Questions
Explain the key differences between full costing and variable costing.
The main difference between full costing and variable costing is the treatment of fixed overhead costs. Full costing includes both variable and fixed costs in the product cost, whereas variable costing only includes variable costs and excludes fixed overhead costs. This means that under full costing, the reported product cost will be higher than under variable costing, as it incorporates all costs associated with production. The choice between these two methods can impact inventory valuation, net income, and management decision-making.
Describe how full costing allocates indirect costs to products.
In full costing, indirect costs, such as overhead expenses, are allocated to products based on a predetermined overhead rate. This overhead rate is typically calculated using a cost driver, such as direct labor hours or machine hours, that represents the activity or resource consumption of the product. By allocating these indirect costs, full costing provides a more comprehensive view of the total cost of producing a product or service, which is useful for pricing decisions, profitability analysis, and inventory valuation.
Analyze the implications of using full costing versus variable costing for managerial decision-making.
The choice between full costing and variable costing can have significant implications for managerial decision-making. Full costing, by including both variable and fixed costs in the product cost, provides a more realistic assessment of the total cost of production. This information can be valuable for pricing decisions, make-or-buy analyses, and evaluating the profitability of different product lines. In contrast, variable costing focuses solely on the variable costs associated with production, which may be more relevant for short-term decision-making, such as determining the optimal product mix. Ultimately, the choice between these two methods depends on the specific needs and objectives of the organization, and managers should carefully consider the trade-offs between the information provided by each approach.
Costs that cannot be directly attributed to the production of a specific product or service, such as overhead expenses like rent, utilities, and administrative salaries.