Question

Without preparing an income statement, explain how would you determine operating income that would be reported under absorption costing sytem?

Answer 1

Absorption costing is a costing system that is used in valuing inventory. It not only includes the cost of materials and labor, but also both variable and fixed manufacturing overhead costs. Absorption costing is also referred to as full costing. This guide will show you what’s included, how to calculate it, and the advantages or disadvantages of using this accounting method.

Components of Absorption Costing

Under the absorption method of costing (aka “full costing”), the following costs go into the product:

• Direct material (DM)
• Direct labor (DL)
• Variable manufacturing overhead (VMOH)
• Fixed manufacturing overhead (FMOH)

Under absorption costing, the costs below are considered period costs and do not go into the cost of a product. They are, instead, expense in the period occurred:

• Variable selling and administrative
• Fixed selling and administrative

Example of Absorption Costing

Company A is a manufacturer and seller of a single product. In 2016, the company reported the following costs:

Variable costs per unit:

• Direct materials cost: $25
• Direct labor cost: $20
• Variable manufacturing overhead cost: $10
• Variable selling and administrative cost: $5

Fixed costs:

• Fixed manufacturing overhead of $300,000
• Fixed selling and administrative of $200,000

Over the year, the company sold 50,000 units and produced 60,000 units, with a unit selling price of $100 per unit.

Using the absorption method of costing, the unit product cost is calculated as follows:

Direct materials + Direct labor + Variable overhead + Fixed manufacturing overhead allocated = $25 + $20 + $10 + $300,000 / 60,000 units = $60 unit product cost under absorption costing

Recall that selling and administrative costs (fixed and variable) are considered period costs and are expense in the period occurred. Those costs are not included in the product costs.

Advantages

There are several advantages to using full costing. Its main advantage is that it is GAAP-compliant. It is required in preparing reports for financial statements and stock valuation purposes.

In addition, absorption costing takes into account all costs of production, such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct materials or direct labor and indirect costs such as plant manager’s salary or property taxes. It can be useful in determining an appropriate selling price for products.

Disadvantages

Since absorption costing includes allocating fixed manufacturing overhead to the product cost, it is not useful for decision-making. Absorption costing provides a poor analysis of the actual cost of manufacturing a product. Therefore, variable costing is used instead to help management make product decisions.

Absorption costing can skew a company’s profit level due to the fact that all fixed costs are not subtracted from revenue unless the products are sold. By allocating fixed costs into the cost of producing a product, the costs can be hidden from a company’s income statement. Hence, absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet.

For example, recall in the example above that the company incurred fixed manufacturing overhead costs of $300,000. If a company produces 100,000 units (allocating $3 in FMOH to each unit) and only sells 10,000, a significant portion of manufacturing overhead costs would be hidden in the balance sheet. If the manufactured products are not all sold, the income statement would not show the full expenses incurred during the period.