# Absorption Costing: Income Statement & Marginal Costing

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• 0:04 Absorption Costing
• 2:05 Income Statement Impact
• 4:12 Marginal Costing
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Costs to manufacture a product include direct materials, direct labor and overhead. In this lesson, you'll learn how overhead is allocated to finished products using absorption and marginal costing.

## Absorption Costing

Mr. Sweet owns the Sweets R Us Company, which manufactures and distributes candy. His company is profitable, but he wonders if all the costs of manufacturing the products are captured and reported accurately. At a recent industry conference, one of his competitors was talking about financial information prepared using absorption costing, and internal information prepared using marginal or variable costing. Mr. Sweet would like to learn more about this these two types of costing systems, and which one he can use for external versus internal reporting.

Manufacturing a product involves direct materials, direct labor and variable and fixed manufacturing overhead. Direct materials represent the cost of materials used directly in the manufacturing process. Direct labor reflects the wages of those employees who manufactured the product. Variable manufacturing overhead varies with the volume of production and an example would be utilities. Fixed manufacturing overhead includes costs that remain the same regardless of how many units are produced, such as the rent that Mr. Sweet pays on his production facility.

It's simple to trace direct materials, direct labor and variable manufacturing overhead costs to a particular product. In absorption costing, fixed manufacturing overhead costs are also allocated to each unit that's produced. As a result, each finished product absorbs all costs related to its manufacture. Fixed overhead is allocated to each unit produced using the formula:

Fixed overhead rate = Estimated fixed overhead costs for the period / estimated activity for the period

Let's assume that Sweets R Us estimates its fixed manufacturing overhead costs to be \$5,000 for the month, and it estimates it will produce 2,500 units of product. The fixed manufacturing overhead rate for this period would be \$2 per unit, which is found by dividing the estimated fixed overhead costs by the estimated activity for the period, or \$5,000 / 2,500 = \$2.

## Income Statement Impact

In absorption costing, fixed manufacturing overhead is allocated to the finished product and becomes part of the cost of inventory. Inventory represents items where manufacturing is complete, but they haven't been sold to the consumer. Due to the treatment of fixed manufacturing overhead, a higher net income is reported on the income statement, which summarizes revenue and expenses for a particular period. Accounting standards require that absorption costing be used since the cost of inventory must include all purchasing, conversion and any other costs to get the inventory ready for sale. This includes direct materials, direct labor and both variable and fixed manufacturing overhead costs.

As an example, let's assume the following information for the Sweets R Us Company. The sales for the period equal \$250,000; the opening inventory is at \$0; the manufacturing costs include direct materials at \$80,000, direct labor at \$60,000, variable overhead costs at \$10,000 and fixed overhead costs at \$20,000; the ending inventory includes 3,000 units, which equals \$51,000; and the selling and administrative expenses equal \$60,000.

Absorption costing includes all manufacturing overhead, both variable and fixed, and is calculated using the cost of goods sold formula. The cost of goods sold formula is:

Cost of Goods Sold = opening inventory + direct materials + direct labor + variable manufacturing overhead + fixed manufacturing overhead - ending inventory

Using the information from the Sweets R Us company, we'd get \$119,000, or \$0 + \$80,000 + \$60,000 + \$10,000 + \$20,000 - \$51,000.

The income statement using absorption costing would look like this:

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