How Do You Increase Net Operating Income Without Increasing Sales Under Absorption Costing?
In general, businesses want to look profitable on paper to help attract investors and customers. If your business is unable to increase sales, you may have to look for other ways to increase your net operating income. Absorption costing techniques can be used to reduce expenses, which will also increase operating income.
The basic formula for calculating net operating income is to take total sales minus cost of goods sold to arrive at gross profit. Then gross profit minus selling and administrative expenses will get you to net operating income. This basic formula will not change when using different accounting methods. However, the cost of goods sold portion may be calculated differently depending on whether variable or absorption costing is used.
In absorption costing, cost of goods sold equals variable production costs plus fixed production costs. Variable costs vary depending on how many units are produced. It can include materials and direct labor used to make each unit. Fixed production costs stay the same regardless of how many units are produced or sold; rent and utilities for the manufacturing facility are examples of fixed costs, which are divided among all products produced and expensed as a part of the cost of goods sold in the year the units are sold. In variable costing, the cost of goods sold is equal to the variable production costs only, because fixed production costs are considered administrative costs rather than product costs. The fixed costs are subtracted from gross profit in the year they are incurred.
Under absorption costing, all fixed production costs are tied to units produced. For example, a company's fixed production costs totaled $300,000 for the year; 90,000 units were produced and 60,000 were sold during the year. Under absorption costing, fixed cost per unit is calculated as $300,000 divided by 90,000, or $3.33 per unit. The amount to be included in costs of good sold for the year is $3.33 multiplied by 60,000, or $200,000. The remaining $100,000 of fixed costs is a component of inventory on hand -- an asset -- and will not be fully expensed until the remaining 30,000 units are sold. Therefore, when production exceeds sales, less of the fixed production costs is expensed as cost of goods sold in the current year. A lower expense for cost of goods sold will result in a higher operating income.
Absorption costing is required for reporting purposes. This means increasing production is a legitimate way to reduce cost of goods sold and increase net operating income. However, having excess inventory can also create problems. Another way to increase operating income is by simply reducing expenses without manipulating production. Look for other suppliers who may be able to supply material for less cost. Condense shipments of material into fewer loads to reduce shipping costs. Negotiate lower advertising rates. Look for ways to improve efficiencies and reduce waste.