The traditional income statement uses absorption costing to create the income statement. This income statement looks at costs by dividing costs into product and period costs. In order to complete this statement correctly, make sure you understand product and period costs.

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The format for the traditional income statement is:

Let’s use the example from the absorption and variable costing post to create this income statement.

When doing an income statement, the first thing I always do is calculate the cost per unit. Under absorption costing, the cost per unit is direct materials, direct labor, variable overhead, and fixed overhead. In this case, fixed overhead per unit is calculated by dividing total fixed overhead by the number of units produced (see absorption costing post for details).

Once you have the cost per unit, the rest of the statement is fairly easy to complete. All variable items are calculated based on the number of units sold. This includes sales, cost of goods sold, and the variable piece of selling and administrative expenses. The matching principle states that we must match revenue with expenses. Therefore, we can only expense the cost of the units that are sold. The units that are not sold end up in inventory.

Start with sales. Take your price per unit and multiply it by the number of units sold.

Sales = Price X Number of units sold

Sales = \$100 X 8,000

Sales = \$800,000

Using the cost per unit that we calculated previously, we can calculate cost of goods sold by multiplying the cost per unit by the number of units sold.

Cost of goods sold = Cost per unit X Number of units sold

Cost of goods sold = \$48.80 X 8,000

Cost of goods sold = \$390,400

Calculate gross profit by subtracting cost of goods sold from sales.

Selling and administrative expenses can be variable or fixed. Therefore, you should treat the selling and administrative costs like a mixed cost. In this case, the variable rate is \$5 per unit and the fixed cost is \$112,000. Write your cost formula and plug in the number of units sold for the activity.

Total selling and administrative expense = \$5 X 8,000 + \$112,000

Total selling and administrative expense = \$40,000 + \$112,000

Total selling and administrative expense = \$152,000

Last but not least, calculate the operating income by subtracting selling and administrative expenses from gross profit.

#### Final Thoughts

Having a solid grasp of product and period costs makes this statement a lot easier to do. Calculate unit cost first as that is probably the hardest part of the statement. Once you have the unit cost, the rest of the statement if fairly straight forward.

There are two major costing methods used for creating income statements in managerial accounting: absorption costing and variable costing. These two methods vary based on the way that fixed overhead is applied to the product cost. Product cost includes direct materials, direct labor, and overhead. These are the costs that are included in cost of goods sold and inventory. Only these costs can be included in inventory.

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#### Absorption Costing

Absorption costing is what you probably think of when you think of product costing. Since the beginning of your managerial accounting course, you have been told that product cost consists of direct materials, direct labor, and overhead. Since we have introduced cost behavior into the course, we know that overhead can be either variable or fixed (direct materials and direct labor are variable costs).

Under absorption costing, we are going to take into account all of the variable product costs and absorb the fixed overhead into the cost of the product.

Let’s look at an example.

Here is some basic cost information for a business. What information is important when we are calculating product cost using absorption costing?

Direct materials, direct labor, variable overhead, and fixed overhead should all be included in the cost of the product using absorption costing. Direct materials, direct labor, and variable overhead are already expressed in per unit figures but fixed overhead is not. We must allocate the fixed overhead to each of the units.

There are two figures we are given: units produced and units sold. Which do you think we should use? You want to make sure that fixed overhead is allocated to all of the units. Therefore, you should use units produced. Using units produced will allow overhead to be allocated to all of the units, those that were sold and those that are still remaining in inventory.

Allocate overhead by dividing the fixed overhead by the number of units. This will give us fixed overhead per unit.

Fixed overhead per unit = \$48,000/10,000 units

Fixed overhead per unit = \$4.80 per unit

NOTE: Fixed overhead per unit will only be \$4.80 per unit when 10,000 units are produced. This is not a variable rate. The rate is not constant. If the company produced 20,000 units, the rate would be \$2.40 (\$48,000/20,000). This rate will fluctuate as production changes.

With the fixed overhead now expressed as a per unit figure, we can add it to the direct materials, direct labor, and variable overhead to calculate the absorption cost per unit. Under absorption costing, the cost per unit is \$48.80.

Absorption costing is required by GAAP and must be used on the external financial statements.

#### Variable Costing

Variable costing is just another form of product costing. As the name implies, only variable product costs are used to calculate the cost per unit of a product. Therefore, we will not include any of the fixed overhead in the cost of the product.

It might be tempting to include variable selling cost because it is also a variable cost, but remember that selling cost is a period cost and is expensed when incurred. Only include product costs in the calculation: direct materials, direct labor, and variable overhead. Notice that the product cost is lower because no fixed overhead is included.

In the next post, we will look at the traditional (absorption) income statement and the contribution margin (variable) income statement.