The contribution margin income statement is a very useful tool in planning and decision making. While it cannot be used for GAAP financial statements, it is often used by managers internally.
The contribution margin income statement is a cost behavior statement. Rather than separating product costs from period costs, like the traditional income statement, this statement separates variable costs from fixed costs.
The basic format of the statement is as follows:
Variable costs, no matter if they are product or period costs appear at the top of the statement. Fixed costs are treated the same way at the bottom of the statement. It is helpful to calculate the variable product cost before starting, especially if you will need to calculate ending inventory.
Let’s run through an example to see how the income statement is constructed. We will use the same figures from the absorption and variable product cost post.
The first thing to remember about any income statement is that the statement is calculated based on the amount of product sold, not the amount of product produced. Therefore, this income statement will be based off the sale of 8,000 units.
To calculate sales, take the price of the product and multiply by the number of units sold.
Sales = Price X Number of units sold
Sales = $100 X 8,000
Sales = $800,000
Next, we need to calculate the variable costs. In the absorption and variable costing post, we calculated the variable product cost per unit.
This covers the product costs, but remember we must include all the variable costs. There is also $5 of variable selling cost that should be included. Multiply the total variable cost per unit by the number of units sold.
Total variable cost = Variable cost per unit X Number of units sold
Total variable cost = ($44 + $5) X 8,000
Total Variable Cost = $392,000
Contribution margin is the amount of sales left over to contribute to fixed cost and profit. Contribution margin can be expressed in a number of different ways, including per unit and as a percentage of sales (called the contribution margin ratio). In the contribution margin income statement, we calculate total contribution margin by subtracting variable costs from sales.
Total contribution margin = Sales – Variable costs
Fixed costs include all fixed costs, whether they are product costs (overhead) or period costs (selling and administrative). One thing that causes the contribution margin income statement and variable costing to differ from the traditional income statement and absorption costing is the fact that fixed overhead is treated as if it were a period cost. All fixed overhead is expensed in the period it is incurred. Under absorption costing, fixed overhead is attached to each unit. Therefore if there are units that are not sold, a portion of the fixed overhead ends up in inventory. That is not the case when using variable costing.
Add fixed overhead and fixed selling and administrative to calculate total fixed cost.
Total fixed cost = Fixed overhead + Fixed selling and administrative
Total fixed overhead = $48,000 + $112,000
Total fixed overhead = $160,000
Last step: subtract fixed costs from contribution margin to calculate operating income.
The contribution margin income statement is all about behavior. Remember the format and ignore the traditional (absorption) income statement. Most students that have trouble with this statement try to relate it back to what is happening on the traditional income statement. Throw out what you know about the traditional income statement when doing the contribution margin income statement. Focus on the format of this statement and you should be fine.
The contribution margin income statement
There are two major costing methods used for creating income statements in managerial accounting: absorption costing and variable costing. These two methods vary based on the way that fixed overhead is applied to the product cost. Product cost includes direct materials, direct labor, and overhead. These are the costs that are included in cost of goods sold and inventory. Only these costs can be included in inventory.
Absorption costing is what you probably think of when you think of product costing. Since the beginning of your managerial accounting course, you have been told that product cost consists of direct materials, direct labor, and overhead. Since we have introduced cost behavior into the course, we know that overhead can be either variable or fixed (direct materials and direct labor are variable costs).
Under absorption costing, we are going to take into account all of the variable product costs and absorb the fixed overhead into the cost of the product.
Let’s look at an example.
Here is some basic cost information for a business. What information is important when we are calculating product cost using absorption costing?
Direct materials, direct labor, variable overhead, and fixed overhead should all be included in the cost of the product using absorption costing. Direct materials, direct labor, and variable overhead are already expressed in per unit figures but fixed overhead is not. We must allocate the fixed overhead to each of the units.
There are two figures we are given: units produced and units sold. Which do you think we should use? You want to make sure that fixed overhead is allocated to all of the units. Therefore, you should use units produced. Using units produced will allow overhead to be allocated to all of the units, those that were sold and those that are still remaining in inventory.
Allocate overhead by dividing the fixed overhead by the number of units. This will give us fixed overhead per unit.
Fixed overhead per unit = $48,000/10,000 units
Fixed overhead per unit = $4.80 per unit
NOTE: Fixed overhead per unit will only be $4.80 per unit when 10,000 units are produced. This is not a variable rate. The rate is not constant. If the company produced 20,000 units, the rate would be $2.40 ($48,000/20,000). This rate will fluctuate as production changes.
With the fixed overhead now expressed as a per unit figure, we can add it to the direct materials, direct labor, and variable overhead to calculate the absorption cost per unit. Under absorption costing, the cost per unit is $48.80.
Absorption costing is required by GAAP and must be used on the external financial statements.
Variable costing is just another form of product costing. As the name implies, only variable product costs are used to calculate the cost per unit of a product. Therefore, we will not include any of the fixed overhead in the cost of the product.
It might be tempting to include variable selling cost because it is also a variable cost, but remember that selling cost is a period cost and is expensed when incurred. Only include product costs in the calculation: direct materials, direct labor, and variable overhead. Notice that the product cost is lower because no fixed overhead is included.
In the next post, we will look at the traditional (absorption) income statement and the contribution margin (variable) income statement.