In accounting and economics, “full cost” refers to the total cost of producing a good or service, including both direct and indirect costs. The concept of full cost is important because it provides a more complete picture of the resources used in the production process, which can aid in decision-making and pricing strategies.
Here’s a breakdown of what constitutes full cost:
- Direct Costs: These are the costs that can be directly traced to the production of a specific good or service. They typically include direct labor (wages for the employees directly involved in production) and direct materials (raw materials used in the production process).
- Indirect Costs (Overhead): These costs cannot be directly linked to the production of a specific item but are necessary for the overall operation of the business. They include costs such as rent, utilities, depreciation on equipment, administrative salaries, and more.
In addition to these, full cost accounting can also consider other types of costs like:
- Opportunity Costs: The cost of the next best alternative that is given up when a decision is made.
- Sunk Costs: Costs that have already been incurred and cannot be recovered.
Understanding the full cost of producing a good or service can help a company determine the minimum price it must charge to cover all of its costs. It’s also crucial in evaluating the profitability of different products or services, helping management make decisions about which activities to continue and which to change or discontinue.
Do note that the approach to including various costs might differ based on the costing method a company follows, like absorption costing (which considers all manufacturing costs) or variable costing (which only considers variable costs).
Example of Full Cost
Let’s consider an example to illustrate the concept of full cost. Let’s say a company named “EcoBikes” manufactures bicycles.
Direct Costs: The direct costs for EcoBikes would include the costs of the raw materials used to build the bicycles, such as metal for the frame, rubber for the tires, and plastic for the accessories. It would also include direct labor costs, which are the wages of the workers who assemble the bicycles.
- Raw materials: $50 per bicycle
- Direct labor: $30 per bicycle
Indirect Costs: Indirect costs, or overhead, might include the costs of utilities for the factory, depreciation of the factory equipment, maintenance costs, salaries of the management, and rent for the factory.
Suppose the company produces 10,000 bicycles a year and the total indirect costs are $200,000 a year. That would mean the indirect cost allocated to each bicycle would be $20 ($200,000/10,000).
Full Cost: The full cost of each bicycle would therefore be the sum of the direct and indirect costs: $50 (materials) + $30 (labor) + $20 (overhead) = $100 per bicycle.
In this case, EcoBikes would need to sell each bicycle for more than $100 just to cover its costs. Anything above $100 would be profit.
Keep in mind this is a simplified example. Real-world costing can be more complex, with companies often using specific cost allocation methods to distribute indirect costs among different products, and considering other costs like opportunity costs and sunk costs. However, it illustrates the basic concept of full cost: summing direct and indirect costs to understand the total cost of producing a good or service.