Companies must use an absorption cost income statement to report to external entities. This method includes all overhead costs in inventory costs, reducing gross profit and providing a more accurate picture of production costs. However, allocating costs to individual units can be challenging, and net income is affected by inventory levels. Some see this method as a more complete picture of financial performance.
In accordance with Generally Accepted Accounting Principles (GAAP), companies are required to use an absorption cost income statement for reporting to any entity or individual outside the company. An absorption cost income statement requires a company to spend all overhead costs on the company’s inventory. This means that costs associated with the manufacturing process, such as labor or materials, are counted as part of the product inventory cost incurred by the business.
When goods are sold, in an income statement of absorption costs, the costs associated with manufacturing goods are transferred from the company’s inventory costs to the company’s costs of goods sold. This action reduces the gross profit earned by the company on each unit of a good sold, compared to how gross profit is calculated on a variable cost income statement. The costs of producing the goods effectively reduce the company’s gross profit margin, providing a more realistic picture of how much the company spends to produce the goods, compared to how much it sells.
Using an absorption cost income statement to report a company’s financial performance presents some challenges. The costs associated with the production of goods may not be easily allocated to the individual units sold by the company. For example, when the production process requires the use of electricity, it may be impossible to accurately measure the amount of electrical energy used to produce each individual product. As a workaround, a company might choose to average production costs with the number of units produced in an effort to allocate an average production cost amount to individual units.
With an absorption cost income statement, a company’s net income is calculated using production costs and the number of units sold by the company. A company’s net income, then, is affected by the amount of inventory the company carries of specific products, during the period covered by a financial report. If the business carries little or no inventory, but all other variables are equal, the business reports a higher net income than if it sells the same number of units but carries more product inventory.
Because of its focus, this type of income statement could also be called total costing. In variable costs, fixed production costs are not included in the cost of producing goods or services. Since an absorption cost income statement takes fixed manufacturing costs into account when calculating the cost of manufacturing products, it is seen by some as a complete or more complete picture of how the company is performing financially.
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