A Revised Income Statement: The Contribution Margin Approach, Case Study Example

Prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 2008.

Marginal Costing

$                                  $

Sales at 19 per unit                                                                                               6,555,000

Variable production units                                                   2,287,500

Add opening inventory                                                        518,500

2,860,000

Less closing inventory                                                        (335,000)

Variable production cost                                                                                        2,470,500

Contribution                                                                                                           4,084,500

Less Fixed Cost

1. Manufacturing overheads 1,600,000
2. Selling and Administration 1,200,000

___________

Net Profit                                                                                                              1,284,500

Absorption Costing

$                                  $

Sales at 19 per unit                                                                                               6,555,000

Standard production costs                                                   3,787,500

Add opening inventory                                                          858,500

4,646,000

Less closing inventory                                                          (555,000)

Variable production cost                                                      4,090,500

(Over)/Under absorbed                                                        100,000                 4,190,500

Gross Profit                                                                                                           2,364,500                                                                                                                                    

Less fixed cost                                                                    (1,200,000)

___________

Net Profit                                                                                                              1,164,500

What are E’s contribution margin ratio, gross profit ratio and operating (net) income ratios?

Contribution Margin rations= Contribution/Sales ×100%

4,084,500 ×100  =62.3%

6,555,000

Gross Profit Ratio

i) Marginal Costing

4,084,500 ×100% =62.3%

6,555,000

ii) Absorption Costing

2,364,500 × 100% =36%

6,555,000

Net Profit Ratio

i) Marginal Costing

1,284,500  ×100% =19.5%

6,555,000

 ii) Absorption costing

1,164,500 ×100% =17.7%

6,555,000

Explain the difference and reconcile operating income for the two methods.

The difference between the outputs of the two methods is foreseen. The reported profit levels using the marginal and absorption costing and marginal costing differ if there is a change in the inventory levels during the period of reporting. The difference is caused by the different inventory valuation methods.

Difference in inventory = Change in inventory × Overhead absorption rate per unit

Reconciliation

Absorption costing profits                              $1,164,500

Add change in inventory (25,000 ×4)          $ 120,000

Marginal Costing profits                                 $ 1,284,500

Where there is a decrease in inventory, the absorption profit is therefore lower than marginal profits. The difference is caused by the point at which the fixed overhead costs are incorporated in the calculation.

If E sells 10,000 additional units, how much better off is the company financially? Which income method did you use? Please explain and show your computations.

If the business sells 10,000 additional units

The marginal costing method is the best method since it gives a realistic estimate of the profits. This is because the fixed overhead costs are incorporated in the product cost as the product is being sold. The cost is therefore passed on to the consumer at this point

$                                  $

Sales at 19 per unit                                                                                               6,745,000

Variable production units                                                    2,287,500

Add opening inventory                                                         518,500

2,860,000

Less closing inventory                                                          (335,000)

Variable production cost                                                                                        2,470,500

Contribution                                                                                                           4,274,500

Less Fixed Cost

i) Manufacturing overheads                   1,600,000

ii) Selling and Administration 1,200,000

___________

Net Profit                                                                                                              1,474,500

The company would therefore make $190,000 more

Which costing method would you recommend to the CFO? Why?

I would recommend marginal costing.

This is because it’s a method of costing that values inventory at the variable production cost. In this method, only variable costs are charged as cost of sales. Fixed costs are treated as period costs and they are charged in full against the profits of the period in which they are incurred. Marginal costing therefore helps identify the extra cost of producing one extra unit as well as the extra profit for selling one extra unit. It’s a very good measure in budgetary controls. In the preparation of a rolling budget, marginal costing would be very ideal. However, absorption costing is good for financial accounting purposes as high volumes of inventory do not have a high impact on the profits.