Manufacturing companies have choices in the way they determine and report their profits. Some choose to utilize the while others choose the income statement. Both income statements offer their own set of advantages and disadvantages. However, the absorption conforms with the generally accepted accounting principles, and it offers a more accurate way of tracking profits in a specific accounting period.
Absorption Costing Defined
Absorption costing by definition means that products produced by a company absorb all the of that company. This includes the direct the company incurred to manufacture the product, such as manufacturing supplies, and necessary such as salaries and utility . The direct or method does not consider both and , 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 and .
Variable depend on the amount of products produced. Fixed costs remain the same no matter how many the company produces. A good example of would be materials and supplies. The more produced, the higher the of materials and supplies. An example of a would be rent. No matter how many are produced, the rent remains the same.
Because an provides a more complete picture of the actual 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 efficiency in , and allows a better opportunity to identify -prohibitive practices. It is also the required income statement method for reporting to the Internal Revenue Service.
For companies that may increase of a product in preparation for increased seasonal , the 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 is moved into general .
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 of sold
– Less and management
To better demonstrate, let’s use the following example to create an .
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 per item by adding , , and for a total of $25.50. Once you have this information, it is relatively easy to configure the rest of the income statement.
Sales are determined by multiplying the price per unit by the total number of sold. For our example, there were 4,000 lamps sold at $50.00 each for a total of $200,000.
To calculate the of sold, the of each unit is multiplied by the number of sold. The per lamp is $25.50 times 4000 lamps sold for a total of sold of $102,000.
To determine and , they must be treated as a mixed because they can be both and . In this example, the rate is $3.50, and the selling and administrative is $56,000. Multiply the rate of $3.50 times the 4000 sold for a total of $14,000. Add the $14,000 to the of $56,000 for a total administrative of $70,000.
The final income statement for this example is:
Less the of sold $102,000
Less and management $70,000
This example also helps to gain an understanding of how both and affect . The higher the of producing a product the lower the . Obviously, a lower has a profound affect on the bottom line of . The is a necessary tool that helps manufacturing companies by breaking down those 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.
In some cases, an increase in the income statement can cause a gain in when manufacturing is increased and more are placed in . This is because the which cannot change are allocated to more even though those have not been sold. Cost of sold will be less, and will increase.