Absorption and Full Cost Pricing
This page covers some basic problems that surface from time to time and that really need to be cleared up. We will discuss absorption and full cost pricing and why period costs are NOT overheads.
Absorption and Full Cost Pricing
A couple of weeks ago I was asked the question: what is the difference between absorption cost pricing and full cost pricing. My answer was, and is, that there is no difference between them as these terms are synonymous with each other.
I got the reply that
"… the OCR [A level Business Studies] syllabus clearly
I was then further told that
" … several A LEVEL textbooks they also distinguish.
I was asked this self same question around three years ago and provided the same answer as I just gave … that correspondent was a tenacious young student who threw a few things back at me so I did a lot of digging to get to the bottom of this problem and wrote an extensive defence of my arguments. Needless to say I have lost my copy of that defence so what follows is the right answer and, thankfully perhaps, a lot less comprehensive than last time.
There is Some Confusion
Let me begin by admitting that there does appear to be confusion over the two terms we are discussing in cost accounting textbooks, let alone the much less specialist business studies books. For example, I came across these learning objectives for a lecture on product costing and overhead allocation from Pat Mould and Peter Fijalkowski as I did a Web search:
To consider bases of cost allocation to products:
Full absorption costing
Why is this confusing? It's confusing because it's suggesting that activity based costing is not a full absorption costing system when clearly it is: ABC is an absorption system by all standards. They do, however, show that full and absorption costing go together!
Nevertheless, you will find such clear statements as:
The approach that we adopted was to allocate all manufacturing cost
to products, and to value unsold stocks at their total cost of manufacture.
Non-manufacturing costs were not allocated to the products but were
charged directly to the profit statement and excluded from the stock
valuation. A costing system based on these principles is known as an
absorption or full costing system.
Absorption costing is a method of inventory costing in which
all variable manufacturing costs and all fixed manufacturing costs are
included as inventoriable costs.
There really is no doubt that when we talk about full cost we are talking about an absorption costing concept and that, as Drury says, absorption cost and full cost are the same thing.
Where does the Confusion come from?
In addition to the possible confusion from Mould and Fijalkowski, let me suggest an additional reason why we have this possible confusion between absorption and full costing.
Horngren has already told us that
That is, when we look at the fine detail of absorption costing as cost accountants then we will be concerning ourselves with the assignment of costs of production or manufacturing.
At the end of this cost assignment process, we will have determined values of the opening and closing stocks of raw materials, work in progress and finished goods and the cost of goods produced and transferred to finished goods stocks.
At this stage, we are only concerned with the costs of raw materials and conversion. All costs that relate to general administration, distribution, marketing, finance and so on are treated, quite properly, as period costs and are excluded from the above cost assignment process. This is, for example, entirely in line with accounting standards from al over the world: for example, from International Accounting Standard 2: Inventories we have
7. The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
Where their present location is the warehouse, the stock room and so on: since there can have been no general administration, distribution, marketing and finance activities having been undertaken in bringing the stock to their present location we can see why the costs associated with them are considered irrelevant for stock valuation purposes.
At this stage, there are organisations that might consider that the cost accountant has done enough and use their stock values as the basis of determining the selling price of those goods. Using the cost plus model, then, the selling price id determined according to the formula:
Setting the mark up is probably the most insecure and difficult part of the process: what should it be and how do we know? After all, this mark up has not only to provide the company with a profit but it has to cover all of the period costs that we have already identified. If we expand the above table we will see this point more clearly:
Using the product value of finished goods is not a good basis for setting the selling price.
That takes care of absorption costing: deriving the cost of finished goods ready for sale. What about full costing, then?
Full costing is exactly the same as absorption costing with the significant exception that we account fully for the period costs when setting the selling price. Without trying to fog the issue with a series of calculations let's look at the example that Horngren et al provide when trying to illustrate the problems in setting a mark up.
The cost accounting techniques use to arrive at each of the four cost bases shown in the table from Horngren et al are exactly the same: confirming yet again that there is no difference between absorption and full costing.
Period Costs are Not Overheads
In cost accounting, we classify the costs of a manufacturer as follows:
These distinctions are quite clear and have been with us for a long time. I have been told that one Business Studies Chief Examiner has in his text book that
"Indirect costs are known as overheads and cover administrative and marketing activities"
this is 50% wrong and the table above clearly shows that: overheads are production costs and administrative and marketing costs are period, non production, costs.
Even when we deal with the costs of a service provider, we would not assume that the overheads are lumped together in the way that the Chief Examiner suggests: we are much more systematic than that!
The purpose of this page has been to try to sort out once and for all the relationship between absorption and full cost pricing and to provide clear definitions of the term overheads.
Horngren CT Foster G and Data SM (2000)
Drury C (1997)
International Accounting Standard 2: Inventories
© Webmaster Duncan Williamson 2003