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    Absorption Income versus Contribution Margin Income: Example

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    The background materials present the computations for both gross profit on sales and contribution margin. Can you give specific benefits to be derived from using the information from computing gross profit on sales as opposed to contribution margin? Is net income always going to be the same regardless of the accounting approach?
    Why don't we use the contribution margin format for external reporting?
    Which income statement is classified by function, and which one is classified by behavior?
    Look at the income statements below before you answer the questions.

    ABC Company sells 10,000 widgets. The company has no beginning or ending inventory. Using the absorption approach (GAAP) the net income of the company is as follows:

    Sales (10,000 @ $20) $200,000
    Cost of goods sold (10,000 @ $12) 120,000
    Gross profit $ 80,000
    Expenses 20,000
    Net income $ 60,000
    Using the contribution margin approach the net income of the company is as follows:
    Sales (10,000 @ $20) $200,000
    Variable cost of goods sold (10,000 @ $8) 80,000
    Contribution margin $120,000
    Fixed expenses 60,000
    Net income $ 60,000

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    Solution Preview

    Absorption Costing Vs Contribution Approach
    1 Introduction:
    There are two approaches of presenting income statement.
    Absorption costing approach 2 Contribution approach
    In absorption approach a portion of fixed manufacturing Expenses is allocated to each unit produced during the period.
    It combines fixed and variable Expenses while determining the cost of goods sold.
    © In Absorption approach all costs of production are considered as product costs.
    (a) Practically It makes no distinction between fixed and variable cost
    (b) It is also known as full costing method in the sense that it absorbs fully direct material, direct labor and both fixed and variable expenses.
    (c)2 Variable or Contribution Approach:
    (d)Variable cost increase or decrease in direct proportion with the Volume, output or the level of activity. For example Direct material, Direct labor and variable manufacturing or selling expenses etc.
    (e)In this approach Fixed manufacturing overhead is not included in product cost but rather treated as period cost and separated completely from the Cost of Goods sold .
    (f)Contribution margin is calculated by deducting total variable cost of goods sold from total sales revenue and Fixed manufacturing and Fixed selling costs are charged against the revenue of each period.
    (g)Net income is thus arrived at after deducting Fixed cost from contribution margin.
    (h)Consequently inventory is not charged with ...

    Solution Summary

    This solution compares absorption income with contribution margin income.