This statement, prepared under absorption costing principles, determines net income by subtracting the total cost of goods sold and operating expenses from revenue. The cost of goods sold includes direct materials, direct labor, and both variable and fixed manufacturing overhead. This method considers all manufacturing costs as product costs, meaning they are initially recorded as inventory and expensed only when the products are sold. As an example, if a company manufactures 1,000 units with total manufacturing costs of $10,000, the cost per unit would be $10. This $10 is then used to calculate the cost of goods sold when those units are sold.
Using this methodology provides a more complete picture of the total costs associated with producing goods, adhering to Generally Accepted Accounting Principles (GAAP) for external financial reporting. It is beneficial for determining profitability by taking into account all production costs, including fixed overhead which is often substantial. Historically, it has been the standard for external reporting, influencing pricing decisions and long-term strategic planning. The full absorption of manufacturing costs is deemed relevant to accurately represent the financial performance of a company.
