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# Absorption Income and Contribution Margin Income Statement

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Europa Publications, Inc. specializes in reference books that keep abreast of rapidly changing political and economic issues in Europe. The results of the company's operations during the prior year are given in the following table. All units produced during the year were sold. (Ignore income taxes.)

Sales revenue.............................................. \$ 2,000,000
Manufacturing costs:
Fixed:.........................................................500,000
Variable......................................................1,000,000
Selling costs:
Fixed............................................................50,000
Variable.......................................................100,000
Fixed..........................................................120,000
Variable..........................................................30,000

1. Prepare a traditional income statement and a contribution income statement for the company.

2. What is the firm's operating leverage for the sales volume generated during the prior year?

3. Suppose sales revenue increases by 10 percent. What will be the percentage increase in net income?

4. Which income statement would an operating manger use to answer requirement (3)? Why?

#### Solution Preview

1. Prepare a traditional income statement and a contribution income statement for the company.
In the traditional form, the costs are grouped by function. The fixed and variable costs are added together.
Cost of goods sold = Total manufacturing cost = 500,000+1,000,000=1,500,000.
EUROPA PUBLICATIONS, INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20XX
Sales \$2,000,000
Less: Cost of goods sold 1,500,000
Gross margin \$ ...

#### Solution Summary

The solution explains how to prepare a absorption income and contribution margin income statement and the related calculations.

\$2.19

## Convert Ekland absorption income statement to a contribution margin income statement

Roland Andersson is the manager of the Ekland Division of Ystad Industries. He is one of several managers being considered for position of CEO, as the current CEO is retiring in a year.

All divisions use standard absorption costing. The division has the capacity to produce 50,000 units a quarter and quarterly fixed overhead amounts to \$500,000. Variable production cost is \$55 per unit. Roland has been looking at the report for the first three months of the year and is not happy with the results.

Ekland Division

Income Statement

For the Quarter Ending March 31, 2012

Production: 25,000 units

Sales (25,000 units)
\$2,500,000

Cost of goods sold

Beginning inventory (10,000 units)
\$650,000

Production costs applied
1,625,000

Total
\$2,275,000

Less ending inventory
650,000
1,625,000

Gross profit
875,000

Selling & general expenses
400,000

Net income
\$475,000

The sales forecast for the second quarter is 25,000 units. Roland had budgeted second quarter production at 25,000 units but changes it to 50,000 units, which is total capacity for a quarter. The sales forecasts for each of the last two quarters of the year are also 25,000 units. Costs incurred in the second quarter are the same as budgeted, based on 50,000 units of production.

Required:

Computations:

Convert the Ekland absorption income statement to a contribution margin income statement for the first quarter. Click here for an example showing how to convert from one approach to another. This example is for guidance only and the numbers have not bearing on the Ekland case. You can also find several videos on YouTube that explain the difference between the two types of income statements.

Prepare absorption and contribution margin income statements for the second quarter for Ekland.

Compute production costs per unit for both approaches and for both years.

Did Roland improve his performance for the second quarter? Indicate the information you used for your assessment.
Can you make any suggestions for reporting in the future?
Do you think Roland should be seriously considered for the CEO position? Why or why not?
Discuss three shortcomings of the absorption approach for internal decision-making.

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