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Income Statement


The format for a traditional income statement is summarized in the table below. Because of the differences between manufacturing firms and retailers or wholesalers, there are separate columns for the two types of entities.

  Revenue Revenue
minus Cost of goods sold, which include direct material, direct labor, variable overhead and fixed overhead Cost of merchandise sold
equals Gross profit Gross profit
minus Selling and administrative expenses Selling and administrative expenses
equals Net income before taxes Net income before taxes
minus Income taxes Income taxes
equals Net income after taxes Net income after taxes

Note that net income after taxes is transferred to the balance sheet as a credit to retained earnings. For the basic layout of the balance sheet, click here

While we are talking about income statements, we need to cover one additional topic. The income statements above are those that would be required for external financial reporting under GAAP (Generally Accepted Accounting Principles). For GAAP, we have to use what is called absorption (or full) costing. Absorption costing requires that fixed manufacturing costs be allocated to inventories and expensed as part of cost of goods sold. The rationale for absorption costing is that the fixed overhead is the cost of the capital resources used in production, and those costs should legitimately be expensed as production is sold. Suppose that  production is greater than sales. Because we can only expense fixed overhead in proportion to sales, some fixed costs wind up staying in inventory, where they will remain until they are sold in a subsequent period. Conversely, that sales exceeds production. We sell everything we had left unsold from a prior period and we sell enough of the "new" inventory so that we wind up with less at the end of the year than at the beginning. In this case, we'll expense all of the fixed overhead allocated to the current year's production, as well as some of the fixed overhead which had been held in inventory from the prior year. It can get a bit messy, but that's how the system works.

Variable costing

However, there is an alternative perspective, known as variable costing. (Variable costing is also known as marginal costing or the contribution margin method.) The proponents of variable costing argue that fixed production costs are more legitimately charged to fiscal periods rather than products. To a certain extent, if fixed costs really are fixed, then we incur the same costs, no matter what the level of output or sales. Under variable costing, all fixed overhead for the year is expensed as a period cost, not as part of cost of goods sold. A variable costing income statement looks like this:

minus Variable manufacturing costs (direct labor + direct material + variable overhead)
equals Contribution margin from production
minus Variable selling and administrative expenses
equals Contribution margin
minus Fixed manufacturing costs
minus Fixed selling and administrative costs
equals Net income

Note that a GAAP income statement groups costs by function. All manufacturing costs are combined in cost of goods sold and subtracted from revenue to find gross margin. All non-manufacturing costs [ = S & A expenses] are deducted FROM gross margin to find net income. In a variable costing income statement, costs are grouped by behavior. All variable costs are deducted from revenue to find contribution margin. All fixed costs are deducted from contribution margin to find net income.

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Copyright 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.
Last modified: August 03, 2005