Full Costing vs. Direct Costing: A Comparative Analysis
Costing Methods in Business
Types of Costs
We analyze various types of costs, including variable and fixed costs, and how they are incorporated into different costing systems. The primary systems we’ll explore are:
- Full Costing
- Direct Costing
- Rational Imputation
Full Costing
Definition
Full costing, also known as absorption costing, incorporates all costs related to production into the cost of the products. The total cost of production for a given period is calculated as follows:
- Consumption of Raw Materials (Direct Cost)
- + Cost of Direct Labor (Direct Cost)
- + Production Overhead Costs (Indirect Costs)
Income Statement Under Full Costing
The income statement under full costing presents the following structure:
- Sales Revenue
- – Sales Returns
- – Sales Discounts
- Net Sales
- – Total Industrial Cost of Goods Sold
- Total Gross Margin or Total Industrial Margin
- – Total Distribution Costs
- Total Commercial Margin
- – Administration Costs
- Operating Result (Internal Performance)
Advantages of Full Costing
- Compares cost price with selling price to determine profitability.
- Allows for detailed analysis of different cost aggregation phases.
- Provides a realistic valuation of permanent inventories (finished goods, semi-finished goods, and work-in-progress).
- Suitable for cost allocation by order number and price determination.
Disadvantages of Full Costing
- The information provided is not sufficient for production decisions (e.g., whether to continue or discontinue a product) as it combines fixed and variable costs.
- Does not consider the impact of changes in activity levels on costs.
- The data provided may not be sufficient for establishing an effective pricing policy.
Direct Costing or Variable Costing
Definition
Direct costing, also known as variable costing, focuses on classifying costs into fixed and variable categories. Only variable costs are assigned to products, while fixed costs are treated as period expenses.
Purpose of Direct Costing
The primary purpose of direct costing is to improve cost management and control, as well as to support decision-making by considering only relevant costs.
Income Statement Under Direct Costing
The income statement under direct costing presents the following structure:
- Sales Revenue
- – Sales Returns
- – Sales Discounts
- Net Sales
- – Industrial Variable Cost of Products Sold
- Gross Margin or Variable Industrial Margin
- – Variable Distribution Costs
- Variable Margin or Commercial Margin
- – Fixed Costs
- Operating Result or Analytical Result
Advantages of Direct Costing
- Simple to apply and requires minimal calculations.
- Useful for cost-volume-profit analysis.
- Facilitates break-even analysis.
- Helps identify and understand product performance, as inventories are valued only with variable costs.
- Suitable for production scheduling decisions and selecting products with higher contributions to company results.
- Guides business policy by helping choose the optimal combination of sales volume and price.
Disadvantages of Direct Costing
- Inventory valuation at variable cost may undervalue inventory compared to full costing.
- Does not provide the total cost of a product, which is necessary for long-term decisions.
- The classification of costs into fixed and variable can be subjective.
Full Cost vs. Direct Cost: A Comparison
- When there are no changes in inventory levels, both methods yield similar results.
- When production exceeds sales, full costing results in higher income for the period.
- Under direct costing, profit remains constant as long as sales remain unchanged.
- In the long term, the results of both methods tend to converge as production aligns with sales.
Rational Allocation Model
The rational allocation model is a partial costing method that does not allocate all costs to products or services. It considers variations in activity levels and separates fixed and variable costs for each activity. It also establishes an idle capacity level for each facility or activity.
Capacity Levels
- Available Capacity or Theoretical Capacity: Assumes 100% operation, disregarding strikes and disruptions.
- Normal Activity: Represents the maximum achievable capacity with available resources, considering work stoppages and interruptions.
- Real Activity: Reflects the actual activity level achieved by the center under study.
Cost Calculation
The rational allocation model calculates the cost of production as the sum of direct variable costs, indirect variable costs, and fixed costs allocated based on a fixed rate. This rate is determined by the ratio of real activity (RA) to normal activity (AN).