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A Revised Income Statement - The Contribution Margin Approach

The E-Company manufactures trendy, high-quality moderately priced watches that it sells on the Internet. As the company's senior financial analyst, you are asked to analyze the overall profitability for the current year. The CFO has heard that there are two different approaches for preparing income statements. You are asked to show the CFO both approaches and explain the advantages or disadvantages of each method. The following data are for the year ended December 31, 2009:

Production capacity is 400,000 units

Beginning inventory, January 1: 85,000 units

Ending inventory, December 31: 55,000 units

Sales for the year are: 345,000 units

Selling price (to distributor) $19.00 per unit

Variable manufacturing cost per unit, including direct materials of $3.50 and direct labor of $1.40

Variable operating/selling cost per unit sold $1.20

Fixed manufacturing overhead $1,600,000

Fixed selling & administrative expenses $1,200,000

Assume costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume the prices and unit costs did not change during the year.

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

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

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

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.

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

Solution Summary

This solution provides a detailed completion of the income statements of the company, as well as calculations of the contribution margin ratio, gross profit ratio, and operating income ratio. A discussion of which method of costing is recommended is also given.