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Full costing, also known as absorption costing, is a management accounting tool used to allocate business costs to a company’s produced consumer goods or services. This cost allocation method allocates all manufacturing costs, including variable and fixed, to produced goods or services. The company’s manufacturing overhead is treated as a period cost in the full costing allocation method, meaning that overhead is charged in the accounting period in which it occurred, not when goods were made. Absorption costing is normally used when reporting inventory valuation to external stakeholders, such as investors or government agencies.
Full costing attributes all manufacturing costs —fixed and variable — to produced products. Fixed costs usually represent production costs that do not vary based on the production level of goods or services. Common fixed costs include rent, property tax, equipment depreciation or insurance companies use to protect their facilities. Management accountants usually allocate fixed costs by taking each item produced and adding an individual portion of the monthly fixed cost to each item.
Variable costs depend on the amount of each production item used when producing goods or services. Raw materials, production labor, utilities or maintenance costs are all variable costs that are applied to products depending on the amount used for producing goods or services. Full costing includes the fixed and variable costs involved in producing the items in the inventory valuation number. Under this method, the inventory number reported on the company’s financial statements represents the actual costs used to produce or create inventory items.
Non-manufacturing costs, usually referred to as manufacturing overhead, include the selling and administrative services used by manufacturing or production companies. Manufacturing overhead costs are treated as a period cost and are recognized on the company’s financial statements as they occur in an accounting period. Full costing usually requires companies to list period costs in a company’s expense accounts on the income statement.
Full costing allows companies to stress the importance of gross profit when producing goods or services. Gross profit is calculated by subtracting the cost of goods sold from total sales. Minimizing the amount of costs allocated to produce goods or services allows companies to increase their gross profit on individual items sold to consumers. While a portion of this gross profit will pay for the period costs or expenses recognized on the company’s income statement, it may also leave the company with a higher net income for the accounting period. The general theory of full costing states that a company will have a higher net income when production exceeds sales. This occurs because companies apply all fixed and variable costs to produced goods or services while not recognizing period costs until they occur.