Absorption and Full Cost Pricing

Introduction

 

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 states
'Pricing: … pricing strategies… cost-based, absorption … full-cost based'"

I was then further told that

" … several A LEVEL textbooks they also distinguish.
eg Jewell 3rd edition: p 403 There is a technical difference between full and absorption costing."

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
Activity based 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.
Colin Drury Costing: an introduction p205

Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.
Charles T Horngren et al Cost Accounting: a managerial emphasis p290

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

Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.
Charles T Horngren et al op cit

Absorption Costing

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.

  • Allocation of direct costs to products: that is raw materials, direct labour and direct expenses
  • Allocation of indirect costs to products: that is indirect materials, labour and expenses that can be directly attributed to products
  • Apportionment of indirect costs to products: that is indirect materials, labour and expenses that cannot be directly attributed to products but that are incurred in the conversion process.

    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:

     
    £
    %
    Production value of finished goods
    80
    80
    Mark up
    20
    20
    Selling price
    100
    100

    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:

     
    £
    £
    %
    Production value of finished goods
    80
    80
    Mark up
    20
    20
    Mark up distributed as follows:
    Administration costs
    5
    Distribution costs
    3
    Marketing costs
    3
    Finance costs
    1
    Profit
    8
    20
    20

    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

    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.

    Cost Base
    Estimated Cost Per Unit
    Markup Percentage
    Markup Component
    Prospective Selling Price
    Variable manufacturing costs
    $483.00
    0.65
    $313.95
    $796.95
    Variable costs of the product
    547
    45
    246.15
    793.15
    Manufacturing function costs
    540
    50
    270
    810
    Full costs of the product
    720
    12
    86.4
    806.4
    Horngren et al p436

    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:

    Product Costs Direct Materials  
        Labour  
        Expenses  
      Indirect (Overheads) Materials  
        Labour  
        Expenses Total Costs
    Period Costs . Administration  
        Distribution  
        Marketing  
        Finance  

    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!

    Conclusions

    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.

    References

    Horngren CT Foster G and Data SM (2000)
    Cost Accounting: a managerial emphasis 10/e
    Prentice Hall

    Drury C (1997)
    Cost Accounting: an introduction 4/e
    Thomson Business Press

    International Accounting Standard 2: Inventories
    International Accounting Standard Committee

    Duncan Williamson
    11 January 2003

  • Write to me at any time

     
    © Webmaster Duncan Williamson 2003