Good morning everyone. Today, we are going to explore two important approaches to costing that businesses use to make decisions about pricing, budgeting, and profitability. These are Full Costing, also called absorption costing, and Contribution Costing, also known as marginal costing. Both approaches have their uses depending on the situation, and by the end of this lesson, you will understand when and how to apply each method.
Let’s start with Full Costing. Full costing allocates all costs, both direct and indirect, to each product. This means that every unit produced carries a share of all fixed costs, like rent or salaries, and variable costs, like materials. For example, if a factory produces 1,000 units of a product and the total fixed overheads are $10,000, each unit will absorb $10 of overheads, plus its direct costs. Full costing is useful for long-term pricing, financial reporting, and valuing inventory. The main limitation is that allocating overheads can be somewhat arbitrary, and it is less helpful for short-term decisions, like deciding whether to accept a one-time order at a discounted price.
Now, let’s talk about Contribution Costing. Contribution costing focuses only on variable costs when calculating the cost of producing one extra unit. The idea is to see how much each product contributes to covering the fixed costs and generating profit. The formula is simple: Contribution equals Selling Price minus Variable Cost. Contribution costing is particularly useful for short-term decision-making, such as accepting special orders, prioritising production when resources are limited, and break-even analysis. Its limitation is that it ignores fixed costs, so it is not suitable for long-term planning or financial reporting.
It is important to know when to use each approach. Full costing is best for long-term pricing, financial reporting, and products with complex overheads. Contribution costing is better for short-term decisions, break-even analysis, and situations where you need to prioritise resources or consider special orders. Many businesses actually use both methods, depending on the type of decision they need to make.
To summarise, full costing gives a complete picture of all costs and is suitable for reporting and long-term planning, while contribution costing focuses on variable costs and helps with tactical, short-term decisions. Understanding both approaches allows managers to choose the most appropriate method and make smarter decisions about pricing, production, and profitability.
By the end of this lesson, you should be able to explain the difference between full costing and contribution costing, give examples of each, and know when to use one approach over the other. This knowledge is key to making effective financial and operational decisions in a business.
