Absorption costing could result in an increase in net income if a company increases its production and its inventory. This occurs because fixed manufacturing overhead is allocated to more production units—some of which will be reported as inventory.
To illustrate, let's assume that a company has no beginning inventory and it has production plans for 100,000 units. Let's also assume that its annual fixed manufacturing overhead is $600,000. If 100,000 units are produced, the fixed manufacturing cost per unit will be $6 ($600,000 divided by 100,000 units). If the 100,000 units are sold for $20 each, the income statement will report sales revenues of $2,000,000 and its cost of goods sold will include $600,000 of fixed manufacturing overhead.
Now let's assume that the company decides to produce 120,000 units even though sales are expected to remain at 100,000 units. Because the fixed manufacturing overhead remains at $600,000 the cost per unit for fixed manufacturing overhead will be $5 ($600,000 divided by 120,000 units produced). In this case the company will report the same sales revenues of $2,000,000 (100,000 units sold times $20) but its cost of goods sold will include only $500,000 of fixed manufacturing overhead (100,000 units sold times $5). The company's balance sheet account Inventory will include $100,000 (20,000 units times $5) of the company's fixed manufacturing overhead.
As was illustrated above, the income statement will report a lower cost of goods sold when production and inventory increased. A smaller cost of goods sold will mean more gross profit and more net income.
