The different methods of costing used in a manufacturing business, result in variations in the format of income statements. If you understand the differences between the various methods of cost, you will understand that these variations are necessary because each method of costing, brings slight changes to the cost of production of the finished goods.

In the article about income statements under marginal cost, we discussed that marginal costs give a higher net profit figure as compared to absorption costing. Here, we are going to discuss the income statement under absorption costing and see how the net profit differs. Before we look at the income statement, let us have a look at what absorption costing is.

Absorption Costing

As we all know, absorption costing is also known as full cost accounting because, under this method, all of them directly attributable costs of production are included. This method does not leave out fixed costs like the marginal costing system, instead, all relevant fixed costs are absorbed into the system.

Absorption costing is a very widely used costing system and public entities are bound by GAAP to use absorption costing when reporting their earnings to shareholders. While the marginal costing system looks only at the variable costs and thus helps management make short-term decisions, the absorption costing system looks at all of the relevant costs of production and helps the management make long-term decisions.

Format of Income statement under Absorption Costing

Let see the format of income statements under marginal costing.

Income Statement under Absorption Costing
 USDUSD
Sales Revenue XXX
Less cost of sales  
Opening inventory (valued at absorption rate)xxx 
Cost of manufactured goods (valued at absorption rate)xxx 
Closing inventory (valued at absorption rate)(xxx) 
(Over)/Under absorption of direct fixed costs(xxx)/xxx 
Cost of sales (xxx)
Gross profit XXX
Less distribution and administrative costs (xxx)
Net profit (XXX)

See the worked example below,

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Gilded limited has presented the following data

Unit Selling Price$10
Unit Variable Cost$6
Fixed cost$300,000
Non-manufacturing fixed cost$100,000
Budgeted activity150,000 units
Sold units140,000 units
Manufactured units170,000 units
Opening inventory for the periodNIL

Using this information we can make the income statement under absorption costing

Income Statement under Absorption Costing
 USDUSD
Sales Revenue 1400,000
Less cost of sales  
Opening inventory(valued at absorption rate)NIL 
Cost of manufactured goods (valued at absorption rate)1360,000 
Closing inventory (valued at absorption rate)(240,000) 
(Over)/Under absorption of direct fixed costs(40,000) 
Cost of sales (1080,000)
Gross profit 320,000
Less distribution and administrative costs (100,000)
Net profit (220,000)

See figures in this calculation

Absorption Rate

The first thing that we need to find out is the absorption rate. If you remember marginal costing, you will remember that we used the sum of marginal variable costs. In absorption costing, we must find out the absorption rate.

The absorption rate is simply the variable costs of manufacturing plus the direct fixed costs of manufacturing. In this example, we know that variable costs are $6 per unit. We simply need to find out the fixed costs which can be done by dividing the fixed costs by the budgeted number of units. I-e 300,000/150000 = $2

The absorption rate or product cost is therefore $6 +$2 = $8

Sales Revenue

Sales revenue was calculated by multiplying sold units (140,000) by the selling price ($10) to arrive at $1400,000.

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Cost of manufactured goods.

The question gave us the number of manufactured goods at 150,000 units. But the actual number of manufactured units is 170,000, so we simply have to multiply the manufactured units by $8 to get $1360,000 as the cost of manufactured goods.

Closing Inventory

The question only gave us the 170,000 manufactured units and 140,000 sold units. Which leaves us with 30,000 units in closing inventory. To arrive at the cost of closing inventory, we simply have to multiply the number of units with the absorption cost i-e $8 to arrive at $240,000.

Over absorption of Fixed Cost

The over-absorbed fixed costs need to be subtracted from the cost of sales. How do we know that the fixed costs have been over absorbed? It is simple.

The budgeted output was 150,000 units and the fixed costs of $300,000 are based on this budgeted output. The fixed overhead absorption rate is, therefore, $2 (300,000/150,000). But we can see that the manufactured units are 170,000, which means that 20,000 extra units have been produced. These extra units include the element of fixed cost because our absorption rate has both variable and fixed costs in it.

This extra overhead needs to be subtracted from the cost of sales. If less than the budgeted units were manufactured, then we would have to add them to the cost of sales. Now, let us look at the cost card.

 USDUSD
Units150,000170,000
Variable Cost (Absorbed at $6/unit)900,0001020,000
Fixed Cost(Absorbed at $2/unit)300,000340,000
Total Cost1200,0001360,000
Absorption rate1200,000/150,000 = $81360,000/170,000 = $8

From this cost card it can be seen that when units were 150,000 the fixed cost was $300,000 but when units increased to 170,000 because of using the absorption rate, the total cost of $1360,000 includes fixed costs as $340,000. This is not right because fixed costs remain the same regardless of the units produced.

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Fixed costs should have remained at $300,000. This means that we now need to remove the effect of over-absorbing $40000, which can be done simply by subtracting it from the cost of sales.

Because absorption costing takes the effect of fixed costs, it is more suitable for long term decision making by the management and the absorption rates also provide a constant rate for the management to base their calculations on, as compared to the marginal cost and average cost, which change with the level of production. This is why under GAAP, financial statements need to follow an absorption costing system.