What is full costing (absorption costing)? A simple explanation
Definition
The full cost method (absorption costing) assigns to each product or service all the costs incurred to produce it: direct materials, direct labour and a share of indirect costs (factory overhead, depreciation of equipment, supervision, rent).
How it works
- Identify direct costs attributable to each product.
- Group indirect costs into cost centres.
- Allocate them using an allocation base (machine hours, labour hours, units produced).
- Add up to obtain the full cost per unit.
Uses
- setting prices that cover all costs;
- inventory valuation: under Canadian accounting standards (ASPE section 3031 and IFRS IAS 2), inventory must include production overhead, which corresponds to absorption costing;
- analysis of profitability by product line.
Limits
The allocation of indirect costs is partly arbitrary and can distort decisions; for short-term decisions, many businesses also use variable (direct) costing. For tax purposes, inventory is valued at the lower of cost and fair market value (s. 10 Income Tax Act), consistently from year to year.
