Financial reporting requires that all the costs incurred to physically make a product, and only the costs incurred to physically make this product are assigned to the product when it goes in the inventory. This approach is called absorption costing because products “absorb” all the costs incurred in the period for their production.
Absorption costing is a stock costing method required for external reporting in which all manufacturing costs are included as inventoriable costs. Product cost thus reflects the full costs of manufacturing the product.
Absorption costing respects the matching principle which states that costs incurred to generate a particular revenue should be recognized as expenses in the same period as the revenue is recognized. Costs related to the factory and productive equipment, even if they are not proportional to the volume of production but “booked” for a period, are all necessary to produce goods. Therefore, it makes sense that the stock carries these costs.
There was however an intense debate about the appropriateness of including fixed capacity costs like the depreciation of the manufacturing equipment or the rent of a factory in inventoriable product costs (Pong & Mitchell, 2006). These costs are incurred whether the company produces or not: they are “fixed” or “committed” in the sense that they are not proportional to the level of activity (we will go back to these notions in Chapter 3).
Variable costs are costs which are proportional to a volume of activity (or cost driver).
Fixed costs are costs which are not proportional to a volume of activity (or cost driver).
Assigning fixed costs to products results in meaningless fluctuations of product cost: products made in periods of low activity are assigned a greater amount (the same amount is divided between a smaller number of units) and products made in periods of high activity are assigned a lower amount (the same amount is divided between a greater number of units). Proponents of variable costing (mislabeled “direct costing” in the U.S.) thus argue that the cost of the capacity booked for the period should be treated as costs of the period (Largayi, 1973).
Variable costing is a method of stock costing in which all variable manufacturing costs are included as inventoriable costs. However, all fixed manufacturing costs are excluded from inventoriable costs; they are considered as cost of the period in which they are incurred.
Gantt and after him the designers of Activity-Based Costing (Kaplan & Atkinson, 1998) suggest a compromise between these two extreme approaches. They recommend assigning to the products the costs of the capacity effectively used during the period rather than the cost of the capacity available. In other words, if a piece of equipment was used at only 80% of its capacity over the period, only 80% of the cost of making this capacity available should be assigned to products made during the period. The remaining 20% should be identified as a cost of unused capacity, a period cost.
Costs of unused capacity are the resources consumed to provide in advance a capacity of production or delivery and not used in the period during which these resources were available.
For financial reporting purposes though, absorption costing is the dominant approach as it is required in most countries. However, some adjustments have been made to this approach to address some of the dysfunctional consequences of allocating capacity costs brought forward by the proponents of variable costing. We will see these adjustments in the section about actual, normal and standard costing. For now, keep in mind that, as we will see in subsequent chapters, absorption costing may be misleading in the context of decision-making, and this is why we will then introduce other methods.
Even broader definitions of “product costs” have been proposed. Full product cost include research and development expenses, all costs of quality, selling and administrative expenses as well as recycling or environmental costs incurred over the full life cycle of a product.
Full product costs are the sum of all the costs incurred to design, produce, sell, deliver and eventually dispose of a product. This kind of cost is the product of life-cycle costing.
Costs of quality refers to the costs of prevention (cost incurred to reduce the likelihood of defects), appraisal (cost incurred to detect non-conform and defective products), non-conformance (to quality standards), internal failure (defects identified before shipping to customers) and external failure (incurred when a customer discovers a defect).
Although you will often see “manufacturing costs” and “product costs” used as synonyms, I recommend using preferably the term “manufacturing costs” to refer to all costs incurred to physically make a product, whether the capacity was effectively used or not, and to avoid the term “product costs” which can be understood in different ways.
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Kaplan, R. S., & Atkinson, A. A. (1998). Advanced Management Accounting. Upper Saddle River: Prentice-hall.
Largayi, J. A. (1973). Microeconomic Foundations of Variable Costing. The Accounting Review, 48(1), 115–120.
Pong, C., & Mitchell, F. (2006). Full Costing Versus Variable Costing: Does the Choice Still Matter? An Empirical Exploration of UK Manufacturing Companies 1988a"2002. British Accounting Review, 38(2), 131–148.