Absorption costing, also called full costing, is what you are used to under Generally Accepted Accounting Principles. Under absorption costing, companies treat all manufacturing costs, including both fixed and variable manufacturing costs, as product costs. Remember, total variable costs change proportionately with changes in total activity, while fixed costs do not change as activity levels change. These variable manufacturing costs are usually made up of direct materials, variable manufacturing overhead, and direct labor. The product costs (or cost of goods sold) would include direct materials, direct labor and overhead. The period costs would include selling, general and administrative costs.
The following diagram explains the cost flow for product and period costs.
The product cost, under absorption costing, would be calculated as:
| Direct Materials |
| + Direct Labor |
| + Variable Overhead |
| + Fixed Overhead |
| = Total Product Cost |
You can calculate a cost per unit by taking the total product costs / total units PRODUCED. Yes, you will calculate a fixed overhead cost per unit as well even though we know fixed costs do not change in total but they do change per unit. We will assign a cost per unit for accounting reasons. When we prepare the income statement, we will use the multi-step income statement format.
We will not get as complicated in our multi-step income statement as the video example but it should have provided a refresher from what you should have learning in financial accounting. For our purpose, the absorption income statement will contain:
| Sales |
| – Cost of Goods Sold |
| = Gross Profit |
| Operating Expenses: |
| Selling Expenses |
| + General and Admin. Expenses |
| = Total Expenses |
| = Net Operating Income |
Gross Profit is also referred to as gross margin. Net operating income is Gross Profit – Total Operating Expenses and is also called Income before taxes. Let’s look at an example:
Bradley Company had the following information for May:
- Direct materials $13,000
- Direct labor $15,000
- Variable overhead $5,000
- Fixed overhead $6,000
- Fixed selling expenses $15,000
- Variable selling expenses $0.20 per unit
- Administrative expenses $12,000
- 10,000 units produced
- 9,000 units sold (1,000 remain in ending finished goods inventory)
- Sales price $8 per unit
First, we need to calculate the absorption product cost per unit:
| Direct Materials | $ 13,000 |
| + Direct Labor | $ 15,000 |
| + Variable Overhead | $ 5,000 |
| + Fixed Overhead | $ 6,000 |
| = Total Product Cost | $39,000 |
| ÷ Total Units Produced | ÷ 10,000 |
| = Product cost per unit | $ 3.90 |
Next, we can use the product cost per unit to create the absorption income statement. We will use the UNITS SOLD on the income statement (and not units produced) to determine sales, cost of goods sold and any other variable period costs.
| Bradley Company | ||
| Income Statement (absorption) | ||
| For Month Ended May | ||
| Sales (9,000 x $8 per unit) | $ 72,000 | |
| – Cost of Goods Sold (9,000 x $3.90 per unit) | 35,100 | |
| = Gross Profit | 36,900 | |
| Operating Expenses: | ||
| Selling Expenses (15,000 fixed + variable 0.20 x 9,000 units sold) | 16,800 | |
| + General and Admin. Expenses | 12,000 | |
| = Total Expenses | 28,800 | |
| = Net Operating Income | $8,100 | |
Remember the following under absorption costing:
- Typically used for financial reporting (GAAP)
- ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
- Can be misleading as some costs are not affected by products
- Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold
- Income statement shows Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and is based on the number of units SOLD.