Full costing can lead to misleading decision-making in several ways. Firstly, the allocation of fixed overheads to products can be arbitrary, especially when these overheads do not directly relate to the level of production. This can result in distorted product costs, potentially leading to incorrect pricing decisions or product line assessments. For example, a product may appear unprofitable due to high allocated overheads, leading to its discontinuation, even though it may be contributing positively to covering fixed costs. Secondly, full costing does not highlight the impact of changes in sales volume on profitability as clearly as contribution costing. In scenarios where decision-makers need to understand the immediate financial implications of sales changes, full costing can obscure the true variable cost impact. Finally, full costing’s focus on long-term, overall profitability can detract from understanding the short-term, incremental profitability of decisions, such as accepting a special order or adjusting pricing in competitive situations. These limitations highlight the importance of using full costing in conjunction with other costing methods for a more rounded approach to decision-making.

A business can indeed use both full costing and contribution costing simultaneously, but for different purposes. Full costing is typically used for external financial reporting, as it aligns with generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). This method ensures that all production costs, including fixed overheads, are reflected in product costs and inventory valuation, providing a comprehensive view of financial performance. On the other hand, contribution costing is used for internal decision-making processes. It helps in assessing the profitability of products or product lines by focusing on variable costs and the contribution margin. This method is especially useful for short-term decision-making, such as pricing decisions, cost control, and evaluating the profitability of specific products or segments. By using both methods, a business can fulfill its legal and regulatory requirements for financial reporting while also gaining valuable insights for internal management and strategic planning.

Contribution costing is not suitable for external financial reporting primarily because it does not comply with generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). These standards require that inventory and cost of goods sold (COGS) include all costs of production, including fixed manufacturing overheads. Contribution costing, on the other hand, includes only variable costs in product costing and treats fixed costs as period costs, expensed in the period they are incurred. This leads to lower inventory values and higher expenses reported in periods of production, potentially distorting the true financial position and performance of a company. For example, if a company produces more than it sells in a period, contribution costing would report lower profits compared to full costing, as the fixed costs are fully expensed. This inconsistency with accounting standards makes contribution costing inappropriate for external reporting, although it remains valuable for internal management purposes and decision-making.

Changes in production levels have differing impacts on cost reporting under full costing and contribution costing. In full costing, both fixed and variable costs are allocated to each unit produced. Therefore, as production levels increase, fixed costs are spread over more units, reducing the cost per unit. This leads to lower COGS and higher profits as production increases, assuming sales remain constant. However, in periods of reduced production, the fixed costs allocated per unit increase, raising COGS and reducing profits. In contrast, contribution costing separates fixed and variable costs. Variable costs fluctuate directly with production levels, but fixed costs remain constant regardless of production changes. Therefore, under contribution costing, profits are more directly tied to sales volume rather than production volume. As a result, contribution costing provides a clearer picture of the relationship between sales volume, variable costs, and profitability, making it more suitable for short-term decision-making.

The choice between full costing and contribution costing significantly impacts inventory valuation and profit reporting. Under full costing, both fixed and variable production costs are included in inventory valuation. This method results in higher inventory values on the balance sheet, as fixed costs are allocated to each unit of inventory. Consequently, when these inventories are sold, the costs are transferred to the cost of goods sold (COGS), impacting profit reporting. In contrast, contribution costing only includes variable costs in inventory valuation, leading to lower inventory values. Fixed costs are treated as period costs and are expensed in the period they are incurred, regardless of sales. This method typically reports higher profits in periods of increasing inventory and lower profits during periods of decreasing inventory. Therefore, the choice of costing method can lead to significant differences in reported profit and inventory values, affecting financial analysis, tax liabilities, and performance evaluation.