Revise Approaches to costing: full, contribution for Cambridge 9609 (5.4.2)

Under full costing, also known as absorption costing, each unit produced absorbs a fair share of all production costs, including fixed production overheads like factory rent and supervisor salaries. This 'fair share' is typically calculated using a predetermined overhead absorption rate (OAR), for instance, based on machine hours or labour hours. The full unit cost is therefore calculated as: Direct Materials + Direct Labour + Variable Overheads + Absorbed Fixed Overheads. This method is required for inventory valuation in published financial statements and is used for long-run pricing strategies to ensure all costs are recovered.

Under contribution costing, only variable costs are considered product costs. Fixed costs are treated as a period cost and are written off in the income statement in the period they are incurred, rather than being allocated to units. This approach is also known as marginal costing, as the cost of producing one extra unit is simply its marginal (variable) cost. The contribution is the amount each unit 'contributes' towards covering fixed costs and then generating profit.

Contribution per unit = SP − VC

Total contribution = (SP − VC) × quantity

Profit = Total contribution − Fixed costs

The choice between full and contribution costing depends entirely on the purpose of the cost information. For long-term strategic decisions, such as setting a product's standard selling price or valuing inventory for the balance sheet, full costing is essential. It ensures that all costs of production are eventually covered, leading to sustainable profitability, and its use is often mandated by financial reporting standards for external accounts.

For short-term, tactical decisions, contribution costing provides clearer insights. It is the preferred method for deciding whether to accept a one-off special order, make a component in-house or buy it, or determine the optimal product mix with a limiting factor. By separating fixed costs, it clearly shows the direct financial impact of a decision on profit, without the distortion of arbitrarily allocated overheads.