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# Absorption Income versus Contribution Margin Income

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Absorption Income versus Contribution Margin Income

The background materials present the computations for both gross profit on sales and contribution margin.
1. Please give specific benefits to be derived from gross profit on sales as opposed to contribution margin? Is net income always going to be the same regardless of the accounting approach?

2. Why don't we use the contribution margin format for external reporting?

3. Which income statement is classified by function, and which one is classified by behavior?

Let me give you a simple example. 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
Gross profit \$120,000
Fixed expenses 60,000
Net income \$ 60,000

#### Solution Preview

Q1. Please give specific benefits to be derived from gross profit on sales as opposed to contribution margin? Is net income always going to be the same regardless of the accounting approach?

ABSORPTION COSTING:
In product/service costing, an absorption costing system apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. Thus under absorption costing, all normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit (sales minus cost of goods sold) is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead.

Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-in-progress and finished goods ...

#### Solution Summary

This compares Absorption Income versus Contribution Margin Income

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