What it means
Under full costing, factory rent, supervisor salaries and machine depreciation are not treated as costs of the period; they are spread across the units made. A unit that has been produced but not yet sold therefore carries part of the factory's fixed cost on the balance sheet as inventory.
That is the difference from variable costing, where fixed factory overhead is charged straight to the income statement each period. Both methods report the same total profit over the life of a business, but in any single period they diverge whenever production and sales volumes do not match.
The consequence is worth understanding before you read a factory's monthly figures. Producing more than you sell moves fixed cost into inventory and flatters reported profit, while producing less than you sell releases stored cost and depresses it, even though nothing about the underlying business has changed.
Applying the method needs an overhead absorption rate, calculated as budgeted fixed overhead divided by a budgeted activity level such as units, machine hours or labour hours. Because the rate is set on a budget, actual results almost always leave an over-absorbed or under-absorbed balance that has to be cleared at the period end.
Full costing is mandatory for statutory accounts and generally for tax, but it is a poor basis for short-run pricing decisions. For a one-off order using spare capacity, the relevant number is variable cost, because the fixed overhead is being paid whether or not the order is accepted.
In practice
Real-world examples.
Example
A ceramics manufacturer reports a strong quarter after building inventory ahead of a seasonal peak. The finance director points out that roughly $180,000 of the profit is fixed overhead absorbed into unsold stock, and warns the board that next quarter will look correspondingly weak.
Example
An electronics assembler sets its overhead absorption rate on a budget of 120,000 machine hours but runs only 104,000. The under-absorbed overhead is written off to cost of sales at the year end, producing an unwelcome charge that had nothing to do with selling prices.
Example
A food producer receives a one-off export order priced below full cost but above variable cost. Because the plant has spare capacity and the order will not affect domestic pricing, management accepts it, since every dollar above variable cost contributes to fixed overhead already committed.
Formula
Calculation
Full cost per unit = direct materials + direct labour + variable overhead + (fixed manufacturing overhead / units produced).
An illustrative furniture maker produces 50,000 units in a year. Direct materials are $18 a unit, direct labour is $9 and variable overhead is $5, giving a variable cost of $18 + $9 + $5 = $32. Fixed factory overhead of $600,000 spread over 50,000 units adds $600,000 / 50,000 = $12 a unit, so the full cost is $32 + $12 = $44.
The company sells 40,000 units at $70 each. Revenue is 40,000 x $70 = $2,800,000 and absorption cost of sales is 40,000 x $44 = $1,760,000, leaving gross profit of $2,800,000 - $1,760,000 = $1,040,000.
Under variable costing the same year shows contribution of 40,000 x ($70 - $32) = $1,520,000, less the whole $600,000 of fixed overhead, giving $920,000. The $120,000 difference is exactly the 10,000 unsold units multiplied by the $12 of fixed cost now sitting in closing inventory.Case study
Seen in the real world.
Pemberton Castings is a fictional foundry used here as an illustrative example. Its bonus scheme paid the plant manager on reported gross profit, and full costing was used for both statutory and internal reporting without any adjustment.
Over two years the plant manager steadily increased production runs beyond demand, and reported gross profit improved every quarter. Inventory rose from about six weeks of sales to nearly twenty, because each extra unit produced carried $9 of fixed overhead onto the balance sheet instead of into the income statement.
The illustrative reckoning came when a design change made a large part of that stock obsolete and a write-down of roughly $1,400,000 landed in a single period. Pemberton kept full costing for its statutory accounts, as it must, but switched internal performance reporting to a variable costing basis and added an inventory turnover target to the bonus scheme.
Watch out
Common mistakes.
- Using full cost per unit as the floor for every pricing decision. For incremental orders with spare capacity, variable cost is the relevant floor, since fixed overhead is already committed.
- Forgetting that the unit cost changes with volume. The fixed overhead per unit falls as production rises, so a full cost calculated at one output level is wrong at another.
- Rewarding managers on absorption profit alone. Building unsold inventory raises reported profit under full costing, which can encourage exactly the behaviour a business should avoid.
Questions
People also ask.
Why is full costing required for financial reporting?
Accounting standards treat fixed production overhead as a cost of getting inventory into its present condition, so it must be included in the inventory value rather than expensed immediately.
What is over-absorbed overhead?
It arises when actual production exceeds the budgeted activity level used to set the absorption rate, so more overhead has been charged to units than was actually incurred, and the excess is credited back at the period end.
Is full costing the same as activity-based costing?
No. Both allocate overhead to products, but activity-based costing traces costs through specific activities and drivers rather than spreading them on a single volume-based rate.
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