Manufacturing companies have choices in the way they determine and report their profits. Some choose to utilize the absorption costing income statement, while others choose the variable costing income statement. Both income statements offer their own set of advantages and disadvantages. However, the absorption costing method conforms with the generally accepted accounting principles or GAAP, and it offers a more accurate way of tracking profits through financial statements in a specific accounting period. The following information will guide you through all of the aspects of the Absorption Costing Income Statement, which will give you an inside look into the behavior of the company.
Absorption Costing Defined
Absorption costing, also known as full costing by definition, means that products produced by a company absorb all the costs of that company. This includes the direct costs the company incurred to manufacture the product, such as manufacturing supplies and necessary fixed costs such as salaries and utility overhead costs. The direct or variable costing method does not consider both and variable costs, and expenses are counted during the period in which they occurred rather than when the product was sold.
In order to understand the different types of income statements, it is important to know the difference between fixed and variable costs.
Variable costs depend on the amount of products produced. Fixed manufacturing costs remain the same no matter how many units the company produces. A good example of variable manufacturing costs would be materials and supplies. The more units produced, the higher the cost of materials and supplies. An example of a fixed cost would be rent. No matter how many units are produced, the rent remains the same.
Because an absorption costing income statement provides a more complete picture of the actual costs to manufacture a product, it is often the preferred method for tracking profitability. This type of income statement tends to be more helpful to company management in evaluating labor efficiency in production and allows a better opportunity to identify cost-prohibitive practices. It is also the required income statement method for reporting to the Internal Revenue Service.
For companies that may increase the production of a product in preparation for increased seasonal sales, the absorption costing income statement is useful because it can help management understand profitability even for products that were not sold during the reporting period. Variable income statements only consider products sold, and the unsold production is moved into general inventory.
Traditional absorption costing income statements are generally set up the same way no matter the type of manufacturing company. The basic format is:
– Less the cost of goods sold
= Equals gross profit
– Less sales and management costs
= Equals operating income
To better demonstrate, let’s use the following example to create an absorption costing income statement.
Company X manufactures lamps.
Direct Materials $10.00
Direct Labor $7.50
Variable Overhead $4.50
Variable Sales $3.50
Fixed Overhead $24,000.00
Fixed Selling and Admin $56000.00
Units Produced 5000
Units Sold 4000
How To Create An Absorption Costing Income Statement
To create the income statement, it is important to first calculate the cost per item by adding direct materials, direct labor, variable overhead, and variable sales for a total of $25.50. Once you have this information, it is relatively easy to configure the rest of the income statement for the current period. The current period will be a good compass for future periods.
Sales are determined by multiplying the price per product unit, also known as the unit product cost or unit cost, by the total number of units sold. For our example, there were 4,000 lamps sold at $50.00 each for a total sales of $200,000.
To calculate the cost of goods sold, the cost of each unit is multiplied by the number of units sold. The cost per lamp is $25.50 times 4000 lamps sold for a total cost of goods sold of $102,000.
To determine sales and administrative costs or administrative expenses, they must be treated as a mixed cost because they can be both variable and fixed. In this example, the variable rate is $3.50, and the fixed selling and administrative cost are $56,000. Multiply the variable rate of $3.50 times the 4000 units sold for a total of $14,000. Add the $14,000 to the fixed cost of $56,000 for a total administrative cost of $70,000.
The final income statement showing the calculations of absorption costing for this example is:
Less the cost of goods sold $102,000
Equals gross profit $98,000
Less sales and management costs $70,000
Equals operating income $28,000
This example also helps to gain an understanding of how both fixed and variable costs affect gross profit. The higher the costs of producing a product, the lower the gross profit. Obviously, a lower gross profit has a profound effect on the bottom line of operating income. The absorption costing income statement is a necessary tool that helps manufacturing companies by breaking down those costs by using the calculation of absorption costing with the help of the absorption costing formula in a way that allows an in-depth review of profitability. Also, see the predetermined overhead rate to see how companies estimate the production costs of a product in advance. When it comes to overhead, there are variable manufacturing overheads and variable overhead costs, which are useful for CVP analysis.
In some cases, an increase in the income statement can cause a gain in net income or net operating income when manufacturing is increased, and more units are placed in inventory. This is because the fixed costs which cannot change are allocated to more units even though those units have not been sold. The cost of the product or cost of goods sold will be less, and gross profit will increase. Inventory carryover and overhead costs are reflected in the ending inventory figure at the end of the period and as the beginning inventory in the following period.