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.

### Make more money now! Try our JOB search.

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.

In the previous post, we discussed using the predetermined overhead rate to apply overhead to jobs. This applied overhead is an approximation. What about actual spending for overhead costs? Let’s review how we got applied overhead.

First, we calculated the predetermined overhead rate by dividing estimated overhead by estimated activity.

Then we multiplied the predetermined overhead rate by the actual activity to calculate applied overhead.

So far, we haven’t used a single actual overhead figure in our calculations. Actual overhead is the amount that the company actually incurred. Imagine that there are two groups of accountants inside a company. One group  is applying overhead based on the actual activity and the predetermined overhead rate. These accountants are adding direct materials, direct labor and applied overhead to jobs to calculate the cost of goods sold on every job that is sold. The second group of accountants is recording actual bills and totalling up actual overhead costs. Except these actual overhead costs are not included in cost of goods sold. They are held off to the side. At the end of the year, the applied accountants and the actual accountants come together to reconcile cost of goods sold to ensure that the actual numbers are what ends up in cost of goods sold at the end of the year.

### Overapplied or Underapplied?

What do we do when we have the actual overhead numbers? We need to compare the actual overhead incurred to the applied overhead that is currently attached to our jobs. We need to see if we applied too much overhead or too little overhead to our jobs.

If too much overhead has been applied to the jobs, we say that overhead is overapplied. If too little overhead has been applied to the jobs, we say that overhead is underapplied. I like to figure this out before I even calculate the dollar figure. Compare applied overhead to actual overhead. Have you applied too much or too little? Remember that applied overhead is what is in cost of goods sold right now. We need to adjust cost of goods sold to actual at the end of the year.

Once you have determined if overhead is underapplied or overapplied, Calculate the difference between applied overhead and actual overhead. This is the amount that you must adjust cost of goods sold to bring it to the actual cost.

If overhead is overapplied, meaning you have too much overhead in cost of goods sold, subtract the amount that is overapplied.

If overhead is underapplied, meaning you have too little overheard in cost of goods sold, add the amount that is underapplied.

Let’s look at an example to help clarify all this.

Example #1

K’s Kustom Furniture estimated overhead at the beginning of the year to be \$567,000. Over the course of the year, K’s applied \$578,000 worth of inventory to it’s jobs. At the end of the year, actual overhead incurred was \$572,000. Calculate the amount of overhead that was overapplied or underapplied. How much cost of goods sold should be reported if unadjusted cost of goods sold is \$2,134,000?

We’ve got a lot of figures for such a short problem. We have three overhead figures. This is why knowing the terminology is really important. If you have the terminology clear, this problem is easy. First, let’s review the terminology.

Estimated overhead is budgeted at the beginning of the year and used to calculate the predetermined overhead rate. Applied overhead is the amount that is added to jobs as work is completed. This is done during the year as work is completed using the predetermined overhead rate and actual activity. Actual overhead is the amount of overhead cost that the company actually incurred.

When determining if overhead has been overapplied or underapplied, we have to compare how much overhead has been applied to how much was actually incurred. Applied overhead is \$578,000. Actual overhead is \$572,000. Estimated overhead is not used here. Remember that estimated overhead is ONLY used to calculate the predetermined overhead rate.

First determine if overhead is overapplied or underapplied. Actual overhead is what should be in cost of goods sold. Applied overhead is what is currently in the account. So right now, there is \$578,000 in the account but there should be \$572,000. Is there too much overhead or too little overhead? There is too much overhead. If we do the math, there is \$6,000 too much in cost of goods sold.

That also means that cost of goods sold is \$6,000 too high. When overhead is overapplied, we must subtract the amount from cost of goods sold.  Cost of goods sold is currently overstated.

\$2,134,000 – \$6,000 overapplied overhead = \$2,128,000 adjusted cost of goods sold.

### Final Thoughts

This post may seem like overkill, but I can’t tell you how many times I’ve seen students get these problems wrong because they did not know the terminology. I often see students confuse estimated and applied overhead. Make sure you know the terminology and the rest of this is easy.

#### Related Videos

Manufacturing companies are companies that make a product. Because these companies have inventory in various stages of production, there are three inventory accounts that we must deal with in order to calculate cost of goods sold. The three inventory accounts are:

1. Raw materials inventory
2. Work-in-progress inventory
3. Finished goods inventory

Each of these accounts must be calculated to see how much inventory from that account moves to the next account and eventually to cost of goods sold. The basic calculation for each of the accounts is the same.

Beginning Inventory
Plus: Something added to the account
Less: Ending Inventory
Equals: materials or goods transferred out of the account

The important thing here is knowing what gets added to the account and knowing the proper label for the amount that is transferred out of the account. This is where terminology is key to your understanding and performing the calculations correctly. When I’m thinking about inventory accounts, I like to imagine three rooms within the product facility, one for each of the types of inventory. Try to think about what is in each room, the costs that are added to the goods in that room and what happens to items that leave the room.

### Raw Materials Inventory

Raw materials inventory is the inventory of materials waiting to go into production. These are components of our product that have been purchased to make our product. In this case, we start with beginning inventory for the raw materials inventory account. What do you think we add to this account? We would add purchases of raw materials. Next, we subtract the ending inventory in the raw materials inventory account which is obtained by counting what is still on hand at the end of the period.

What happened to the stuff that is no longer there? Those materials were requisitioned by employees to use in the production process. They are being used to make our product. We call the materials that were taken from the room materials used in production.

Those materials were transferred into work-in-progress inventory.

Raw materials inventory is pretty straight forward.

### Work-In-Progress Inventory

Now that we have put materials into production, what else goes into the cost of our product? The three product costs are direct materials (which we have already placed in the room), direct labor, and manufacturing overhead. These three accounts are also called manufacturing costs. Add the cost of materials used in production to direct labor and manufacturing overhead costs. These costs are our “something added to the account.”

We have not yet figured in beginning and ending inventory for the work-in-process account. Just like the previous room, take beginning inventory and add your total manufacturing costs (our “something”) then subtract ending inventory. If goods transfer out of this room, it is because they are finished. Those goods are called cost of goods manufactured because they have finished the manufacturing process. They are now complete and have been moved to the finished goods room.

When calculating work-in-progress, add your materials used in production, direct labor cost, and manufacturing overhead cost to get total manufacturing costs. Then the formula is similar to our raw materials calculation.

### Finished Goods Inventory and Cost of Goods Sold (FINALLY!!)

We have finally made it to the last room. We have transferred cost of goods manufactured into finished goods inventory. For this room, this is our “something”. Add beginning inventory and subtract ending inventory balances for finished goods inventory and we are done.

The items that leave the finished goods inventory room leave because they have been sold and therefore, are called cost of goods sold. The formula for this calculation is very similar to both of our previous calculations.

Once you have completed these calculations, the income statement for a manufacturing company is exactly the same at the income statement for a merchandising company. Both statements use cost of goods sold to calculate gross profit, then subtract selling and administrative expenses (or operating expenses) to arrive at operating income.

### Final Thoughts

While the calculations for cost of goods sold for a manufacturing company may seem overwhelming, remember that the calculations for each inventory account are very similar:

Beginning Inventory
Plus: Something added to the account
Less: Ending Inventory
Equals: materials or goods transferred out of the account

When you try to create a story to explain the process, you will not need to remember the formulas. Think about how the materials are moving through the company and into production, where labor and overhead are added. When goods are finished, they transfer to the finished goods inventory account. Once they are sold, they are transferred out of the finished goods account to the income statement as cost of goods sold.

Merchandising companies sell products but do not make them. Therefore, these companies will have cost of goods sold but the calculation is much easier than for a manufacturing company. Expenses for a merchandising company must be broken down into product costs (cost of goods sold) and period costs (selling and administrative).

Just like all income statements, the first line is revenue. In the case of a business that sells a product, we refer to revenue as Sales or Sales Revenue. This lets the reader know that the company generates its revenue from the sale of products rather than the delivery of services.

### Cost of Goods Sold

Next, we subtract cost of goods sold. Cost of goods sold is the cost of all the products (goods) that were sold during the period. If the company uses a perpetual inventory system, cost of goods sold is being calculated every time a sale takes place.  In this case, no calculation is needed. We can simply take the amount from the cost of goods sold account on the trial balance. And you thought you could forget everything from financial accounting!

If the company uses a periodic inventory system, we must do some calculations to figure out cost o f goods sold. Under a periodic inventory system, all goods purchased as placed in the Purchases account, not the inventory account. When sales are recorded, there is no adjustment to inventory and cost of goods sold like there is in a perpetual system. Therefore, at the end of the year, we must look at how much was purchased and physically count how much inventory is left in order to manually calculate cost of goods sold.

Under a periodic system, we add beginning inventory to the cost of purchases. This gives us goods available for sale. Goods available for sale is the maximum value of goods that could be sold. If we sold every unit we had on hand and had no inventory left at the end of the year, goods available for sale would equal cost of goods sold. If there is inventory remaining, we must subtract the ending inventory from goods available for sale to calculate cost of goods sold.

To calculate cost of goods sold under a period inventory system:

Beginning Inventory
Plus: Purchases
= Goods Available for Sale
Less: Ending Inventory
= Cost of Goods Sold

Let’s look at an example to help illustrate the point.

Example #1

Kingram Pencil Pushers sells pencils to office supply stores and other retailers around the world. On January 1, the company’s inventory was \$41,000. During the year, the company purchased \$895,000 worth of pencils. A physical count of the inventory on December 31 revealed that there were \$23,000 worth of pencils remaining. Calculate cost of goods sold for the year.

Whenever you are working on a word problem, the first thing you want to do is remove the numbers from the problem and label them. We are told that January 1 inventory is \$41,000. How would you label this number? If you said beginning inventory you are correct. January 1 is the beginning of the year, hence our beginning inventory.

\$41,000 beginning inventory

How would you label \$895,000? Well we are told this is what the company purchased, therefore this is the amount of our purchases.

\$41,000 beginning inventory
\$895,000 purchases

Can you guess what the last number is? Ending inventory! If January 1 is the beginning of the year then December 31 is the end of the year.

\$41,000 beginning inventory
\$895,000 purchases
\$23,000 ending inventory

What is the problem asking us to do with these numbers? Calculate cost of goods sold.

\$41,000 beginning inventory
\$895,000 purchases
\$23,000 ending inventory
?????? cost of goods sold

Okay, let’s think about this logically. We need to figure out what we sold. Now we can jump to the formula or we can try to think this through without the formula. What is cost of goods sold? It’s the stuff we sold, therefore it is no longer in the building. So if we take the stuff we could have sold (goods available for sale) and subtract the stuff we have left, we can figure out what was sold.

What is the maximum amount of goods that were available for sale? Well we had some pencils, \$41,000 worth of pencils actually. Then we purchased more pencils, \$895,000 worth. So if we add the pencils we had, plus the pencils we bought, that tells us how many pencils we had available that could have been sold.

So we could have sold \$936,000 worth of pencils but we know we had some pencils left so our cost of goods sold must be less than \$936,000. Cost of goods sold CANNOT be more than goods available for sale. I can’t stress this point enough because this is where a lot of people mess up this calculation. If you keep in mind that cost of goods sold cannot be more than goods available for sale, it might save you points on your next exam.

I have \$23,000 worth of pencils leftover. These pencils were not sold. So if I take the number of pencils I could have sold and subtract what I did not sell, that will tell me what I did sell.

Of the \$936,000 in pencils we could have sold, \$913,000 were sold. That is the answer to the problem.

### Putting together the income statement

It’s been a long, strange journey to get here but we are finally ready to do our income statement. Once you have cost of goods sold, the rest of the statement is fairly easy. Here is the format:

Sales
Less: Cost of Goods Sold
=Gross Profit
=Operating Income

This is called the traditional format income statement. Later on in the course, we will discuss another format for the income statement called the contribution margin income statement. This statement breaks out costs into product and period costs. Gross profit is the amount from sales that is left over after your product is paid for. This is an important figure for many companies because it lets the company know the average percentage of each sale left over to cover operating expenses and generate profit.

Let’s look at an example of a traditional format income statement for a manufacturing company:

You will notice that there is less detail in this statement than there was in the service company income statement. You can add all the detail if you wish but many times that causes the statement to become a bit cluttered, especially if you are putting in a subtotal for selling expenses and another for administrative expenses. Many times selling and administrative expenses are called operating expenses. These terms are used interchangeably. Sometimes, you will just see operating expenses or selling and administrative expenses and the total without the breakdown shown above. This format is also perfectly acceptable.

### Final thoughts

When creating the income statement for a merchandising company, it is important to break costs out into product costs and period costs. If you are working with a company that uses a perpetual inventory system, cost of goods sold will already be computed for you. In a period system, you will have to do some calculations to compute cost of goods sold. Focus on what is actually happening, the business process, and the calculations are much easier. Don’t forget to calculate gross profit (sales – cost of goods sold). Operating expenses and selling and administrative expenses can be used interchangeably to refer to period costs.

It is important to identify the type of company you are working with in managerial accounting. Depending on the type of company, you will identify different costs and set up reports differently. There are three major types of companies we will deal with in this course:

1. Service companies
2. Merchandising companies
3. Manufacturing companies

### Service companies

Service firms make up the largest business sector in the United States. Service companies are those that do not sell a physical product but instead provide services to their customers. Service firms include accounting firms, law firms, marketing firms, IT services firms, banks, dry cleaners, health care organizations, educational institutions and many other businesses we interact with on a daily basis.

One major difference between service companies and the other two types is that service companies do not have cost of goods sold because there is no product being sold. Service firms also do not have inventory, also because no physical product is being sold. There many be direct costs associated with providing the service, but no physical product.

### Merchandising companies

Merchandising companies are those which sell products but do not make products. Merchandising companies are broken up into two different types: retailers and wholesalers.

Retailers sell products directly to the end user. Staples, Wal-Mart, Target, American Eagle, GAP, and Home Depot are all retailers. They sell products that consumers and businesses use, rather than resell.

Wholesalers buy products from manufacturers and sell them to other merchandising companies, usually retailers. For example, most small breweries will use a distributor to help get their beers into stores and restaurants. These distributors have established relationships with local stores and restaurants, making easier for small breweries to get their beers to the public. A distributor is a wholesaler. Wholesalers are sometimes referred to as “middlemen” because they act as an intermediary between a manufacturer and a retailer.

Merchandising companies purchase inventory (an asset) and sell that inventory. When inventory is sold, the asset is considered used up and the cost of that inventory is transferred from the balance sheet to the income statement as an expense. This expense is called cost of goods sold. For merchandising companies, the inventory account can also be referred to as merchandise inventory.

### Manufacturing companies

Manufacturing companies are companies that make make a product. Monster Beverages, Dell Computers, Boeing, and General Motors are all companies that produce a product. These companies use labor and machinery to turn materials into a product. Some manufacturing companies sell their products directly to the end user, like Boeing. Some companies like Dell, sell their product directly to consumers and to retailers. Monster Beverages and General Motors sell their products to retailers who sell the product to the end user.

All manufacturing companies have three different inventory accounts to account for the steps in the production process.

1. Raw materials inventory – Raw materials are the components that companies use to produce their products. Don’t let the word “raw” lead you to think that this account is full of wood, plastic, metal or bolts of fabric. Many companies purchase components already manufactured and use them in their finished products. For example, Dell purchases processors from Intel to put in their computers. These processors are considered raw materials until those processors actually go into a computer. Raw materials are any materials that have not yet been used in the production process.
2. Work-in-progress – Companies are continuously making products, which means that at the end of each day or week or month there are products that are not finished. These products have entered the manufacturing process but are not completed. Work-in-progress is inventory that has gone into the production process but has not yet been finished. Think of an aircraft at Boeing that does not have the seats or engines installed, but the rest of the plane is built. We cannot call this raw materials, but we also cannot say that it is finished. This plane would be considered part of work-in-process.
3. Finished goods inventory – When a product is finished it is transferred to finished goods inventory. Typically when we think of inventory we think of finished goods inventory, the stuff that is ready to be sold to our customers. Once a product is classified as finished goods inventory, no additional costs can be added to the product. This is a very important concept when we start talking about types of costs.

### Hybrid companies

Many companies do not fit neatly into one of these categories. For example, restaurants make a product (meals), sell products it does not make (wine and beer), and provides a service (serving the meal). These companies are considered hybrid companies. When classifying companies, make sure to consider that a company could fit into more than one of the categories above.

### Final Thoughts

Considering the type of company you are working with can help you better identify the types of costs the company will incur, how those costs should be allocated and the types of reports that would be useful in the planning, decision making and controlling aspects of managerial accounting.