1. Explain the main differences between absorption and contribution income statements. Will net income always be the same under the two approaches? If not, explain the difference.
An absorption costing income statement is created for stakeholders apart from the company’s own employees and internal management. This method ensures that all overhead costs are included in the inventory of the company. In other words, all costs that are directly linked to manufacturing including; labor and material are added to the inventory. Consequently, the cost of manufacturing is transferred from the inventory costs to the cost of goods sold by the company. A higher cost of goods sold would lead to lower gross profit margin, but this provides a realistic figure of the company expenditures incurred in selling the goods.
Another method of formatting income statements is the contribution income statement. The behavior of the data used in the preparation of the income statement rather than the function of the data. The relationship between the fixed and variable costs can be calculated through this method, and this is specifically helpful in the cost analysis. Unlike the absorption costing income statement, the contribution income statement is prepared for internal use only. Managers, owners and other internal users can easily see how the finances and resources of a company are being utilized through this method.
The net operating income generated using the absorption costing income statement and contribution income statement would vary. This difference is a result of the difference in treatment of the fixed overhead manufacturing cost. Under the absorption costing method, a proportion of the fixed manufacturing overhead cost is attributed to the ending inventory, which reduces the burden on the current period and is transferred to the following period. However, in the contribution income statement the fixed overhead manufacturing cost is charged to the income statement for the current period. No costs of the current period are passed onto the next period (Taylor).
2. Comment specifically on why companies feel the need to create yet another income statement in a different format. What information can the company gleam from this approach that is helpful as a tool in the decision making process.
Income statements prepared under the absorption costing method are useful for outside users of accounts. External users of accounts are more interested in knowing the profitability and costs of the firm without going into the details. The absorption costing method does not provide a break-up of the costs that the company has incurred. On the other hand, the contribution income statement provides a detailed analysis of the costs which the company incurs during a specific period. The internal users of accounts would be more interested in viewing the income statement prepared under the contribution method as it provides the clear division of costs.
The management would be more interested in the contribution income statement rather than the absorption costing income statement. Even though tax reporting is done through the absorption costing method, the management is an internal user of the account and would find it useful to use the contribution income statement when making decisions. They can easily allocate costs as either variable or fixed, and this would be essential information when making key decisions.
3. Explain situations in which break-even analysis would be a useful tool. Provide a specific example.
A break-even analysis may be a useful tool to make sound business decisions. It provides accurate results to a great extent about the profitability of a business idea or situation (Tracy, 2004). The greatest advantage of a break-even analysis is that it may be applicable to all products and services being offered by the firm. A business may use a break-even analysis to determine the least number of units that it must sell in order to cover its costs. As there are certain fixed costs which a firm would have to incur regardless of the number of units sold; therefore, a break-even analysis would identify these fixed costs. The variable costs may be projected as the number of units sold increases. This is important for firms to identify because they do not want to enter the diseconomy of scale.
If a particular company incurs a cost of $10,000 per month, and can sell the product for $1,000 each. The cost, the company, incurs to manufacture one unit is $800; therefore, the profit contribution per margin is $200. The contribution per unit would be divided by the fixed costs of the firm that would give us a break-even level of 50 units. This means the company must sell at least 50 units every month to cover its costs and if they sell any units above 50 would give them a profit.
Taylor, E. (n.d.). Full-Costing Income Statement vs. Variable-Costing Income Statement. Small Business. Retrieved March 20, 2014, from http://smallbusiness.chron.com/fullcosting-income-statement-vs-variablecosting-income-statement-20350.html
Tracy, B. (2004, November 15). Conducting a Break-Even Analysis. Entrepreneur. Retrieved March 20, 2014, from http://www.entrepreneur.com/article/73782