Contribution margin is one of the most important concepts in managerial accounting. It is used extensively in planning and decision making because it is much easier to use than absorption costing, especially as variables change in the planning process.
Contribution margin can be defined in a number of different ways. Contribution margin per unit is price less variable cost per unit. Total contribution margin is sales less total variable costs. These are the two definitions you will see most often for contribution margin. I like to define contribution margin as the amount from each unit that contributes to fixed cost and profit.
Let’s look back at the contribution margin income statement:
Notice that contribution margin less fixed cost is profit. In order to make a profit, total contribution margin must be greater than fixed costs. Once all of our fixed costs are paid for, any additional sales generate profit.
But how much profit? Each unit would generate profit equal to the contribution margin for that unit. If the contribution margin per unit is $10, then each additional unit sold would provide an additional $10 of profit.
Contribution margin is most often expressed as a monetary unit, but we can also express it as a percentage of price. This is called the contribution margin ratio. The contribution margin ratio tells us the percentage of each sales dollar that becomes contribution margin
Contribution margin ratio = contribution margin per unit / price
Contribution margin ratio = total contribution margin / sales
We can also look at variable cost as a ratio. The variable cost ratio tells us the percentage of each sales dollar that would go toward variable cost.
Variable cost ratio = variable cost per unit / price
Variable cost ratio = total variable cost / sales
As long as price and variable cost remain the same, these ratios will remain the same. It does not matter if the company sells 10 units or 1 million units, the percentage of each sale that becomes contribution margin or does to cover variable costs is the same.
Let’s look at an example to illustrate how to calculate contribution margin and these ratios.
Hangout Limited, LLC sells one product priced at $40 per unit. The variable costs (direct materials, direct labor, variable overhead and variable selling) is $25 per unit. Calculate the contribution margin per unit, the contribution margin ratio and the variable cost ratio.
We know that contribution margin is price less variable cost. Therefore, contribution margin is:
$40 – $25 = $15
That means that for every unit we sell, $15 will go to cover fixed cost and profit. Once the fixed costs are paid, $15 per unit becomes profit.
Now calculate the ratios. We’ll start with the contribution margin ratio. Contribution margin ratio is contribution margin per unit divided by price per unit.
$15 / $40 = 37.5%
What does that mean? For every dollar of revenue the company brings in, 37.5% or 37.5 cents will become contribution margin. This also tells us that 37.5% of every sale is available to pay fixed costs or generate profit.
The variable cost ratio is variable cost per unit / price.
$25 / $40 = 62.5%
This tells us that for every unit sold, 62.5% will go to cover variable costs.
These ratios are important as we start to look at planning and decision making using contribution margin.
The traditional income statement uses absorption costing to create the income statement. This income statement looks at costs by dividing costs into product and period costs. In order to complete this statement correctly, make sure you understand product and period costs.
The format for the traditional income statement is:
Let’s use the example from the absorption and variable costing post to create this income statement.
When doing an income statement, the first thing I always do is calculate the cost per unit. Under absorption costing, the cost per unit is direct materials, direct labor, variable overhead, and fixed overhead. In this case, fixed overhead per unit is calculated by dividing total fixed overhead by the number of units produced (see absorption costing post for details).
Once you have the cost per unit, the rest of the statement is fairly easy to complete. All variable items are calculated based on the number of units sold. This includes sales, cost of goods sold, and the variable piece of selling and administrative expenses. The matching principle states that we must match revenue with expenses. Therefore, we can only expense the cost of the units that are sold. The units that are not sold end up in inventory.
Start with sales. Take your price per unit and multiply it by the number of units sold.
Sales = Price X Number of units sold
Sales = $100 X 8,000
Sales = $800,000
Using the cost per unit that we calculated previously, we can calculate cost of goods sold by multiplying the cost per unit by the number of units sold.
Cost of goods sold = Cost per unit X Number of units sold
Cost of goods sold = $48.80 X 8,000
Cost of goods sold = $390,400
Calculate gross profit by subtracting cost of goods sold from sales.
Selling and administrative expenses can be variable or fixed. Therefore, you should treat the selling and administrative costs like a mixed cost. In this case, the variable rate is $5 per unit and the fixed cost is $112,000. Write your cost formula and plug in the number of units sold for the activity.
Total selling and administrative expense = $5 X 8,000 + $112,000
Total selling and administrative expense = $40,000 + $112,000
Total selling and administrative expense = $152,000
Last but not least, calculate the operating income by subtracting selling and administrative expenses from gross profit.
Having a solid grasp of product and period costs makes this statement a lot easier to do. Calculate unit cost first as that is probably the hardest part of the statement. Once you have the unit cost, the rest of the statement if fairly straight forward.
What Is a Discount?
We all love discounts, but why would a business offer offer a discount on their products? Typically, a business might offer a discount to increase sales, make an unhappy customer happy or incentivize a customer to pay quickly.
Understanding Payment Terms
Typically when customers purchase inventory, they are not expected to pay cash. The seller extends credit to the buyer, but extending credit comes at a cost for the seller. The seller does not have the cash and therefore must pay its bills from other sources, either cash reserves or borrowing. The seller may lose out on interest earned on cash reserves or possibly even pay interest on loans or lines of credit. In order to decrease the time a receivable is outstanding, a company may offer a discount for fast payment. When a company offers this type of discount, it is listed in the payment terms on the bill:
Payment terms: 2/10, n/30
What does this mean? Well, first notice the comma. That means there are two parts to the payment terms. So let’s look at each part, starting with 2/10. This does not mean that the bill is due on February 10. It means “2% discount if paid in 10 days”. Therefore, if the date of the bill is February 15 and you pay the bill on or before February 25, you get a 2% discount off the balance due. What happens if you don’t pay in the first 10 days? For that, we have to look at the statement after the comma: n/30. The “n” in the statement stands for net. So the statement tells us that the net, or entire, amount is due in 30 days. Taking it all together, the statement is as follows:
Payment terms: If paid within 10 days, we will give you a 2% discount, or you can pay the full balance within 30 days.
Can you see why businesses prefer 2/10, n/30? Takes up a lot less space on a bill. What happens if you don’t pay with bill within 30 days? After 30 days, your payment is now late and the seller can add on late charges or interest, depending on state law.
Let’s look at some examples using payment discounts.
Medici Music purchased instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 with terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Medici Music.
The first step is to break down the information. Medici purchased inventory for $5,000 on August 13 and paid the bill on August 20. Looks like we have two transactions. Wait! We are dealing with inventory. Have you realized we are missing something? If not, take a second to see if you can figure it out. <Insert Jeopardy theme here> Is Medici using periodic or perpetual inventory? Remember, we are about to record an entry dealing with the movement or change in value of inventory! I know we are talking about payments here but we are still talking about inventory. That trumps the payment discussion!
We will look at this transaction under both methods so you can see the difference. Before we start looking at each method, let’s start by discussing what is the same under each of the methods. We have two transactions. The first transaction deals with the purchase of the inventory. The second transaction deals with the payment for the instruments already received.
When working with discounts, we generally calculate the discount and record it at the time of payment. Some textbooks may show you two different methods for recording the discount, one in which the discount is recorded at the time of the purchase and one where the discount is recorded at the time of the payment. I prefer the second method. When you record the discount at the time of the purchase and the discount is not taken because the buyer does not pay within the discount window, we must alter the payment entry to undo the discount taken in the first entry. By recording the discount at the time of the payment, we are only recording a discount that has actually been taken and we never need to undo something from the first entry.
First, we need to record the entry to show the purchase of the inventory.
Notice that we used Inventory, because under the perpetual method, whenever the value of inventory is changing, we must show that change in the account.
Now let’s look at the second transaction. We are paying off what is owed but we are receiving a discount. We must show the accounts payable fully paid off, so we must debit Accounts Payable for $5,000. How are we paying the balance? With cash, so we must credit Cash for the amount of cash being paid. Because of the discount, the amount will be less than $5,000. If we take 3% of $5,000, we calculate the discount as $150. Therefore, the amount of cash needed to fulfill the obligation is $4,850.
What do we do with the $150? Remember the rules for perpetual inventory. If the value of the inventory is changing, we need to target the inventory account. Is the value of the inventory changing? Currently, we have $5,000 in the Inventory account for this purchase. Did we actually pay $5,000 for the inventory? Well, no, we didn’t. We actually paid $4,850 for the inventory. Therefore, the value of the inventory is not $5,000 but $4,850. We need to reduce the value of the inventory by $150 to reflect the discount received. Now, we have all the information we need to complete the second entry.
Now the process is complete. The Accounts Payable balance is now zero and the Inventory balance is $4,850 which matches what we actually paid for the inventory.
Under the periodic method, we do not update the value in the inventory account until we do the adjusting entries at the end of the period. Therefore, we should never use the inventory account in purchase transactions for companies that use the periodic method. Instead, we use the purchases account.
Let’s look at the first entry.
Pretty similar to the perpetual method, except for the use of the purchases account. The second entry will also be similar to the perpetual method, except for one difference. Can you figure out what that difference would be?
We will not be using the Inventory account. Instead we will use an account related to the Purchases account. We do not use the Purchases account because we want to preserve the balance in that account, in case we need to match it up with purchase documents. In order to preserve the original balance in the Purchases account, we will use a contra account. A contra account is an account that is linked to an account but acts in the opposite way. It acts contrary to the account it is linked to. Since Purchases has a normal debit balance, the contra account will have a normal credit balance because it will be used to decrease the value in the Purchases account. The account we will use is called Purchase Discounts (very tricky, huh?). Here is the entry:
The Sales Side
So far, we have looked at the purchase side of the transaction. What about the sales side? Let’s look at our original example again. This time, we will look at it from the seller’s perspective.
Medici Music purchases instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 (with a cost of $3,000), terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Whistling Flutes, LLC.
When recording sales transactions, we still must be concerned with whether the company uses perpetual or periodic inventory. We will review perpetual inventory first.
Under the perpetual method, when inventory changes or the value changes, we must record that change. When a business sells merchandise, inventory is leaving the building, therefore the amount and value of the inventory left is changing. There will be two parts to the August 13 entry. The first part will record the sale and increase in an asset (Accounts Receivable). The second part will record the change in Inventory and the cost of the sale. Let’s look at the entry:
The value of Inventory dropped $3,000, which moves to the income statement as an expense.
Now let’s look at the entry on August 20. This is the date that Whistling Flutes, LLC gets paid in full. However, because of the discount, the Company will not receive the full $5,000. Therefore, we must show the obligation fully paid even though the amount received is less than the amount in Accounts Receivable. The amount of the discount is 3% of $5,000 or $150. The amount of cash received is $4,850. Is Inventory changing? No, the payment on August 20 has no effect on Inventory. We will use a contra account, Sales Discounts, to record the discount amount.
By using a contra account, the company knows how much its sales were over the course of the year and how much was lost because of discounts and other items. This is good information for managers to have in order to make decisions about the effectiveness of company policy.
How would the entry be different under a periodic system? On the sales side, the only difference is the fact that we would not track the change in inventory at the time of the sale. The rest of the entry is exactly the same. Let’s look at both entries together, since we already discussed the methodology. Again, the only difference is that we do not track the changes in inventory under the periodic system.
Read Transactions Slowly!
The biggest problem students have with this topic is confusing purchase and sale transactions. I have had students do the problem perfectly, except they give me the journal entries for the purchase when I ask for the sale or vice versa. Spend extra time if needed to make sure that you understand what the transaction actually means. Do not jump right into the entries until you know what is happening in the transaction. Typically, a problem will state which company you should do the entries for. Go back through the transactions to see if the company is the buyer or seller. Sometimes, I will even note that when I am reading the problem. Read the transactions carefully or you may lose a lot of points on a problem you know how to do.
Sales Entries: Periodic and Perpetual Methods
Purchasing Inventory: Periodic and Perpetual Journal Entries
What is Inventory?
Inventory is an asset account composed of items a company is planning to sell to customers. In financial accounting, we deal primarily with merchandising companies. A merchandiser is a company that purchases products from other companies to sell to customers. There are two major types of merchandisers: wholesalers and retailers. Wholesalers are middlemen. They purchase products from manufacturers and then sell them to retailers. Retailers sell products to the end users, either individual consumers or businesses who will use the product.
Perpetual and Periodic Inventory Systems
Every business that deals with inventory must decide how it will track its inventory. Large retailers and even some small retailers have computer systems which track inventory coming into the business and each item as it is sold. This is called a perpetual inventory system. According to Merriam-Webster, perpetual means “happening all the time or very often.” When a company using perpetual inventory, like Target, gets products shipped to them, all products are scanned into the computer system to let the system know how many units of each product the store has. When items are purchased, the computer system not only records the sale of the product (the revenue), it also records the decrease in inventory. When you purchase a roll of paper towels, the checkout system tells the store there is one less roll of paper towels in inventory.
What if the business doesn’t have a computerized inventory system? It would be very difficult to manually record how many of each item the company has at all times. These businesses use a periodic inventory system. The company tracks the dollar value of purchases and then counts what is left over at the end of the year. If the business knows what it had at the beginning of the year and how much it purchased, this tells the business how much product it could have sold. We call this goods available for sale. When we subtract how much we have left, called ending inventory, from goods available for sale, we can calculate how much we sold. We call this cost of goods sold.
Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold
We call this a periodic system because we only know the exact balances in inventory at the end of each period, usually the end of the year. The business must do an inventory count and do an entry to adjust the inventory account to the proper dollar value. The offset account for this adjusting entry is cost of goods sold.
Does a perpetual inventory system negate the need for a physical count? Absolutely not! All businesses must count inventory at least once a year. There are many reasons why physical inventory would not match the computer records. Theft, damaged goods and cashier error can all cause inventory errors. I worked for a number of retailers in high school and college and each of them did inventory counts multiple times a year to look for inventory errors.
Journal Entries: Purchasing Inventory
We stated earlier that under the perpetual system, changes in inventory are always recorded. Therefore, if inventory levels are changing, either because inventory is increasing or decreasing, we must include the Inventory account in the journal entry. Let’s look at some examples.
Example #1 – Perpetual Inventory
On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a perpetual inventory system.
Break down this statement. What is happening here? ABC is purchasing inventory, which means it is acquiring or getting inventory. Therefore, the balance in inventory is going up. What is the company exchanging for this inventory? Because the transaction is on account, ABC is not paying for the inventory today. Instead, the company is promising to pay for the inventory in the future. The account we use for that promise is accounts payable. Here is the journal entry:
Notice we used the inventory account in the journal entry because the company uses the perpetual inventory system. How would this entry be different if we used the periodic system?
Example #2 – Periodic Inventory
On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a periodic inventory system.
Remember the formula we used to calculate cost of goods sold under the periodic inventory system:
Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold
In order to do this calculation, we must keep purchases separate from inventory. Therefore, we need an account to place those purchases in. We will use an account called Purchases (not very creative, is it?). That is the only difference in the journal entry.
At the end of the year, we will close out the purchases account to update the balance in inventory after a physical count has been completed. We will discuss that process at the end of this discussion.
Journal Entries: Selling Inventory
In a perpetual inventory system, we must always include inventory in our journal entries when the balance in the account is changing. When we sell inventory to generate revenue, the balance in the inventory account is decreasing. Therefore, we need to add that information to the entry. Let’s look at an example.
Example #3 – Perpetual Inventory
On August 2, ABC company, which uses a perpetual inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.
Break down the transaction. What is happening here? ABC sold stuff to another company on account. The stuff ABC sold was purchased for $600. Therefore, ABC has a $1,000 sale and the cost of that sale is $600. First record the sale, then record the inventory adjustment. Here is the journal entry:
Because the company uses a perpetual inventory system, we not only have to record the sale, we also have to record the change in inventory. Now let’s look at the transaction under a periodic inventory system.
Example #4 – Periodic Inventory
On August 2, ABC company, which uses a periodic inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.
When using a periodic inventory system, the company only updates the inventory balances periodically or occasionally. That means that we are not tracking inventory with every journal entry. Inventory is only updated at the end of the period (quarterly or annually). Since we are not constantly tracking the inventory balances, we do not include the change in inventory in our journal entry.
Under periodic inventory, the sales transaction looks just like those we have done previously for service based companies. All we need to do is record the revenue.
That’s it. Record the revenue and you are done.
When working with inventory, it is important to keep the difference between perpetual and periodic straight in your mind.
Under perpetual inventory, we are constantly updating the balance in inventory. Anytime the quantity or value of inventory changes, it must be recorded to the Inventory account. This includes purchasing inventory, selling inventory and transactions related to returns and purchase discounts.
Under periodic inventory, we are only updating the balance in inventory periodically. Therefore, the only time you should use the Inventory account is when doing the adjusting entry to close out the Purchases account. When purchasing or selling inventory, do not use the inventory account. For purchases, use the Purchases account. When selling inventory, only record the sale. Inventory is not part of the transaction.
Introduction to Periodic and Perpetual Inventory
Sales Entries: Periodic and Perpetual Methods
Purchasing Inventory: Periodic and Perpetual Journal Entries
When to Recognize Revenue
Revenue recognition is one of the most important concepts in accounting. Deciding when to record revenue and expenses can have a huge impact on the financial statements. Incorrectly recording revenue that has not been earned can inflate profits and give potential investors or lenders incorrect information about the company’s future profitability.
Revenue should be recorded when it is earned, essentially when the work is done. For some businesses, this is fairly simple. When I complete a tax return for a client, I have earned revenue. When a retailer sells a product, revenue is earned. It does not matter when payment is received; the work is completed and therefore the revenue should be recorded. Payments do not affect the recognition of revenue.
When deciding how to record transactions involving revenue, there are two important questions you should ask yourself:
- Did the company do the work?
- Did the company get paid?
The following chart should help guide you through the process of determining if revenue should be recognized.
Notice the first question is regarding the work. This is the most important factor. Once we have determined it work has been done, then we can look at payment information to determine what the debit should be in the entry.
Let’s look at some examples.
K’s Bounce House Adventures rents bounce houses to individuals and corporations for parties. K’s has the following transactions during the month of February. Record the necessary journal entries.
Feb 2 – K’s agrees to provide a bounce house for a corporate function on February 10 for $300. The companies sign a contract stating that payment will be made on the date of the function.
Feb 4 – K’s provides a bounce house for a birthday party and gets paid at the end of the party, $250.
Feb 5 – K’s provides two bounce houses for a town picnic, $700. K’s must bill the town and will receive payment within 30 days.
Feb 7 – K’s signs a contract to provide a bounce house for a birthday party on Feb 20 for $350. The contract requires the customer to pay 50% of the balance today and the rest the day of the party.
Feb 10 – K’s provides the bounce house for the contract signed on Feb 2 and is paid.
Feb 13 – K’s provides a bounce house for a function booked in January. The customer paid the entire amount of the contract, $275, when the function was booked.
Feb 20 – K’s provides the bounce house for the contract signed on Feb 7 and is paid the remaining balance.
Feb 25 – K’s receives the payment from the town event on Feb 5.
For each of the transactions, ask yourself the two questions above. The solutions are listed below with explanations. Try working through the transactions before looking at the solutions. Take notes on the transactions you had trouble identifying. Usually there is a pattern. Find your weaknesses and work on them. Write your own transactions for those types of entries.
Click here for the solutions to the transactions.
Basic Journal Entries, Part 1
Basic Journal Entries, Part 2