How to Compute Operating Income Using the Traditional Costing System

The traditional costing system is a system by which a firm incurs certain costs related to manufacturing, and those costs are then allocated as incurred over the units manufactured using standard manufacturing overhead rates. The end result is that each unit that is manufactured has its costs properly allocated, allowing the firm to determine its product’s cost of manufacture.

By using the traditional costing system, a company can compute their operating income by subtracting their total costs of goods sold from their total revenues. Operating income is found by subtracting net operating expenses from gross margin

To compute this for your company, simply follow these steps:

Step 1.

Compute the total number of units to be produced in order to meet projected sales by adding together the beginning finished goods inventory, plus production minus engineering changes less ending finished goods inventory. The result is called actual units.

Step 2.

Multiply actual units by standard cost per unit for all materials, labor and manufacturing overhead (based on the actual number of direct labor hours, machine hours or other measures used in applying manufacturing overhead). The result is called total standard cost for actual units.

Step 3.

Subtract total standard cost for actual units from sales dollars to obtain total variable profit (or loss) in dollars.

Step 4.

Add fixed costs (less any portion of fixed costs included in the unit product cost) to total variable profit (or loss) to obtain operating income.