in this video we're gonna do an example of how to use absorption costing to calculate company's operating profit or loss so we've got some cost data right here and also sales data we've got selling price per unit we've got direct materials direct labor variable manufacturing overhead fixed manufacturing overhead and fixed SGA and then we've got some production and sales data down here for three years and we'll calculate the operating profit or loss for each of those years we're gonna need to know the beginning balance of inventory and ending balance of inventory because this fixed manufacturing overhead in some cases can be deferred to future periods we'll get into that so the first thing is when we calculate the selling price and direct materials used directly but all those things we just multiply them by the amount of sales for the period which if you notice there's exact same amount of units sold each period and try to make this a simple example so there's 10,000 units sold each period so for example revenue for each period will be five hundred and fifty thousand dollars and that's just fifty five dollars times ten thousand units sold and so we see sales revenue fifty five hundred and fifty thousand every period so let me just put in the years here so there's 2020 2021 then if you look at direct materials it's four dollars a unit ten thousand units sold in each period so each period that is going to be forty thousand dollars really the only thing that doesn't follow this pattern is fixed manufacturing overhead and that's the trick with absorption costing is how to deal with fixed manufacturing overhead so this is what we're gonna be trying to calculate here everything else is pretty simple fixed SGA 60,000 every period okay its 60,000 every period very variable manufacturing overhead was $25 per unit we sell ten thousand so that's 250 thousand in each period so let's focus on the fixed manufacturing overhead and ignore those other kind of trivial details in 2019 we figure out our fixed manufacturing overhead per unit so we said well there's 150 thousand for the entire period of fixed manufacturing overhead divide that by ten thousand that we produced does $15 a fixed manufacturing overhead per unit but we sell 15 or all 10,000 so actually 10,000 times 15 is 150 thousand dollars so that's 150 thousand dollars okay so it's really actually the first period is exactly the same as it would be if we were using variable costing where so anytime the amount you produce and the amount you sell are exactly the same and you're gonna get the same outcome as variable costing in year two in 2020 we've got a difference because we actually produce 15,000 but we only sell 10,000 so here's how that becomes a little tricky so here's 150,000 fixed manufacturing overhead divided by the 15,000 we produce to get the per unit fixed manufacturing over it it's ten dollars ten dollars okay that's just a hundred and fifty thousand divided by the 15,000 we produced we're spreading the manufacturing overhead the fixed manufacturing overhead across all the units we produced but then we only sell 10,000 so ten thousand times ten dollars is a hundred thousand dollars so you might be thinking hey what will happen here we had 150,000 and fixed manufacturing overhead for 2020 yeah we're only recognizing a hundred thousand that's because 50,000 of that 150 that was in 2020 is going to be deferred until 2021 it's being pushed into the future it's B it's being attached to inventory because we have ending inventory of 5000 if you want another way to figure it out instead of figuring out the per unit a fixed manufacturing overhead and multiplying by the sales you could just think about it kind of logically and say look we produced 15,000 units we only sold 10,000 that means there's 5,000 and ending inventory 5,000 divided by the 15,000 we produced is one third okay so basically one third of what we produced is going so one third of the 150,000 which happens to be 50,000 is going to be deferred till 2021 okay so we're basically saying we're gonna expense two-thirds 10/15 of the 150,000 but then 5/15 is going to be deferred to the 2021 now so so now we've got our fixed manufacturing overhead is different for each of those periods okay now in 2021 we have the opposite of happening of 2020 where we actually sell more than we produce because in this period we start with 5,000 units already in beginning inventory remember we had deferred some of that that 50,000 of the fixed manufacturing overhead but we only need to produce now 5,000 so we produce 5,000 that's we start with five we produce five so that gives us 10 and we sell all 10 so there's no ending inventory what does that mean that means that we're not going to defer any of our fixed manufacturing overhead going forward it's all all 150 is going to be recognized here in 2021 because there is no ending inventory there's nothing to be deferred but remember we also add 50 of the 150 for 2020 that got deferred to 2021 so the 2021 is actually going to be the 50000 from 2020 that was deferred plus 150,000 of 2021 okay so that's this is actually gonna be $200,000 so notice the only thing that is different with absorption costing the only thing that's a real trick is how to deal with the fixed manufacturing over it it's different each period now what does that mean in terms of our operating profit or loss well in the first period in to me the first year 2019 we actually have a loss of ten thousand which is the same we would've had if we were using variable costing but then in 2020 we have a profit of 40,000 why do we have a profit seems weird because actually we sold the exact same amount of units in every single period why would we sell the same amount of units and yet have a profit here in a law here and the reason is is that it's just because we produced more than we sold so some of that fixed manufacturing overhead got deferred until the next period yeah so and then in the next print in 2021 when that deferred stuff from 2020 catches up we actually have a lot more fixed manufacturing overhead because it's not just 2021 it is from the prior year - so then we have a sixty thousand dollar loss this doesn't seem to make sense this is why a lot of people like variable costing because if you did variable costing it would just be a hundred and fifty thousand a fixed manufacturing overhead expensed every single period so this wouldn't be 100 it'd be 150 this wouldn't be 200 to be 150 so if you did variable costing you would have a loss every period of ten thousand and they all add up to the same if if you add up either wait so this this is absorption costing here and that if you add these up you end up with thirty thousand dollars of losses and then if you add up these here under variable costing you get thirty thousand dollars of losses so it's really a question of timing that's the difference between absorption costing and variable costing and with absorption costing a manager just by basically making the decision to produce more units than they sell in any given period can defer some of the fixed manufacturing overhead to a future period and then make the current period appear to be more profitable