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Under the Generally Accepted Accounting Principles (GAAP), businesses must use an absorption costing income statement for reports to any entities or individuals outside of the company. An absorption costing income statement requires a company to expense all overhead costs to the company’s inventory. This means costs associated with the manufacturing process, such as labor or materials, are counted as part of the product inventory cost incurred by the company.
When the goods are sold, on an absorption costing income statement the costs associated with manufacturing goods are transferred from the company’s inventory costs to the costs of the goods sold by the company. This action reduces the gross profit earned by the company on each unit of a good sold, compared to how gross profit is calculated under a variable costing income statement. The costs from the production of the goods effectively shrink the company’s gross profit margin, providing a more realistic picture of how much the company spends to produce the goods, versus how much it sells the goods for.
Using an absorption costing income statement for reporting a company’s financial performance provides some challenges. The costs associated with producing goods might not be easily assigned to the individual units sold by the company. For example, when the production process requires the use of electricity, it might be impossible to measure exactly how much electrical output was used to produce each individual product. As a workaround, a company might choose to average the production costs with the number of units produced in an effort to assign an average production cost amount to individual units.
With an absorption costing income statement, the net income of a business is calculated using both production costs and the number of units sold by the business. The net income of a business, then, is affected by how much inventory the business carries of specific products, during the period covered by a financial report. If the business carries little to no inventory, but all other variables are the same, the business reports a higher net income than if it sells the same number of units but carries a higher inventory of products.
Because of its approach, an absorption costing income statement might also be called full costing. In variable costing, fixed production costs are not included in the cost of producing goods or services. Since an absorption costing income statement does take fixed manufacturing costs into consideration when calculating the cost of making products, it is seen by some as a full or more complete picture of how the company is performing financially.