5.11 - Full Costing
The meaning and stages of full costing
Full costing is a method that assigns all costs, both direct and indirect, to each product produced by a business. This approach ensures every expense is accounted for in the cost per unit, providing a complete picture of production expenses.
Stages in full costing for single-product businesses
- Identify and add up all direct costs, such as materials and labour directly linked to production.
- Calculate the total overheads (indirect costs) for a specific time period, including items like rent or utilities.
- Add the total direct costs to the total overheads to find the overall costs.
- Calculate the average cost per unit by dividing the total costs by the number of units produced.
Formula for average cost per unit
Where:
- Total costs = Direct costs + overheads (£)
- Output = Number of units produced
Worked example - Calculating average cost per unit in a single-product business
A business produces 500 units of a product in a month. Direct costs total £3,000, and overheads are £2,000. Calculate the average cost per unit.
Step 1: Identify the values
- Direct costs = £3,000
- Overheads = £2,000
- Output = 500 units
Step 2: Calculate total costs
Total costs = £3,000 + £2,000 = £5,000
Step 3: Apply the formula
Allocating indirect costs in multi-product businesses
When a business manufactures multiple products, assigning indirect costs (overheads) becomes more complex because these costs are not directly tied to any single item. Accurate allocation is essential to determine the true cost of each product and inform decisions like pricing.
Challenges in multi-product allocation
- Indirect costs must be divided among products using a fair basis, as simplistic methods can distort the actual expenses.
- A consistent allocation method should be applied over time to allow reliable comparisons between periods.
- The chosen method needs to reflect the real use of resources by each product for meaningful results.
Methods for allocating indirect costs and associated problems
Several approaches exist for distributing indirect costs in multi-product settings, each aiming to reflect how products consume resources. However, these methods can lead to inaccuracies if not chosen carefully.
Common methods for allocating indirect costs
- Proportion of total direct costs - Overheads are divided based on each product's share of overall direct costs.
- Proportion of total factory space - Allocation depends on the space each product occupies in the production area.
- Proportion of total labour costs - Overheads are assigned according to each product's portion of total labour expenses.
- Proportion of output - Distribution is based on each product's share of total units produced.
Problems with simplistic overhead allocation
- Inaccurate cost calculations - Dividing overheads equally among products ignores differences in resource use, leading to misleading unit costs.
- Disproportionate impacts on volumes:
- Products with higher production volumes may be allocated unfairly high overheads, making them seem more expensive than they are.
- Products with lower volumes could receive excessively high overhead shares, distorting their profitability.
- Limitations of direct cost allocation:
- Some products may need more factory space despite having lower direct costs, resulting in under-allocation.
- Products relying heavily on machinery might consume more electricity, even if their direct costs are low, leading to imbalances.
More precise allocation often involves basing overheads on the proportion of direct costs each product incurs, but this still requires adjustments for factors like space or energy use.
Worked example - Allocating indirect costs in a multi-product business
A business produces two products, A and B. Total overheads are £4,000. Product A has direct costs of £6,000, and Product B has £4,000. Allocate overheads using the proportion of total direct costs and calculate the total cost for each product.
Step 1: Identify the values
- Total overheads = £4,000
- Direct costs for A = £6,000
- Direct costs for B = £4,000
- Total direct costs = £6,000 + £4,000 = £10,000
Step 2: Calculate proportions
- Proportion for A = £6,000 ÷ £10,000 = 0.6 (60%)
- Proportion for B = £4,000 ÷ £10,000 = 0.4 (40%)
Step 3: Allocate overheads
- Overheads for A = £4,000 × 0.6 = £2,400
- Overheads for B = £4,000 × 0.4 = £1,600
Step 4: Calculate total costs
- Total cost for A = £6,000 + £2,400 = £8,400
- Total cost for B = £4,000 + £1,600 = £5,600
Uses and limitations of full costing
Full costing provides a comprehensive view of product expenses, making it valuable for certain business scenarios, especially in single-product operations. However, it has drawbacks that can affect its reliability for decision-making.
Uses of full costing
- Pricing decisions - Offers a solid foundation for setting prices, particularly in businesses producing one main product, by ensuring all costs are covered.
- Performance comparison - Enables businesses to compare costs across different time periods, provided the allocation method remains consistent.
- Complete cost allocation - Ensures every expense, direct and indirect, is assigned to products, giving a full picture of unit costs.
Limitations of full costing
- Lack of precision in overhead allocation - Does not always tie overheads to the actual expenses incurred by each product, potentially leading to distorted figures.
- Inconsistencies from poor methods - Inappropriate allocation approaches can create unreliable data, making it risky for key decisions.
- Dependency on output levels - Unit costs depend on actual production matching forecasts; a drop in output raises the overhead per unit, increasing costs.
- Need for consistency - Valid comparisons over time require unchanging allocation methods, which may not always suit evolving business needs.