The traditional income statement, also called absorption costing 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.
The basic format is to simply show the sales less the cost of goods sold equal gross profit. And also show the gross profit less the selling and administrative expenses and that equals the operating income.
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, the 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 the 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 the 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.
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.
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