Both absorption and contribution income statements provide the interested parties with the information on company’s revenues, expenses, profits and losses. According to Ross (2011), both types of income statements may seem similar from the first glance, as the first line depicts company’s revenues, while the bottom line shows company’s profits for the accounting period. However, the system of cost accounting is what distinguishes one type of income statement from another.
Brealey (2001) states that absorption costing is used during the preparation of financial statements for external purposes, such as tax reports, annual reports to shareholders and other external documents. This method of cost accounting requires that all manufacturing costs shall be included into total product cost. In particular, this relates to direct materials, direct labor, variable and fixed manufacturing overhead. Some group of costs such as fixed and variable general, selling and administrative expenses are referred to as period costs and are not included into product costs. Thus, if company had produced specific amount of units in a given period, but had sold only some part of the goods produced, some of the fixed and variable SGA expenses will not be included in the income statement, while product is still in the inventory.
Contribution income statement is a slightly different way to measure company’s revenues and profits. In the case of contribution or variable costing, product costs are only comprised of variable manufacturing costs, such as direct materials, direct labor and variable manufacturing overhead. Contribution income statement also treats some costs as a period expense, and, thus, excludes these costs from total product cost. These period expenses include fixed manufacturing overhead, and fixed and variable selling, general and administrative costs. Under this accounting method, bottom line does not depend on the amount of produced and sold goods. All costs are only associated with the amount of product sold. Contribution income statement is very useful for short-term financial planning and usually used for company’s internal purposes. This accounting method allows managers to calculate contribution margin generated by each unit of good sold, as well as conduct a break-even analysis.
We may now conclude that company’s net income may be different depending on the type of cost accounting which was used during the preparation of the annual income statement. Net income in these two cases will always be different if a firm produces more than it sells and increases its inventory stock. According to Ross (2010), variable costing is more efficient in the short term financial planning, as it does not create incentives for the management to manipulate with the inventory stock in order to artificially increase profit levels. Under absorption accounting method, fixed manufacturing costs are spread between total units produced, not only units sold. As a result, management may be increasing production and inventory stock in order to reduce Cost of Goods Sold account. This will result in higher profits in the bottom line. Contribution margin income statement accounts all costs only to the products which are actually sold and does not manipulate with figures.
Contribution income statement provides us with a lot of important information about the cost structure of a given product. Variable costing method allows management to differentiate fixed and variable costs associated with their business. As a result, company’s management may easily conduct a break-even analysis to determine how many units of particular product it shall sell in order to be profitable. The preparation of break-even analysis requires several steps. First, management need to differentiate between variable and fixed costs from contribution margin income statement. Secondly, they need to perform the analysis and find out whether revenues received from each single unit sold are enough to cover variable costs associated with the production of this unit. If price of the product exceeds per unit variable costs, that means that by growing sales volume company may cover its fixed costs and become profitable. To find out the minimum amount of units a company shall sell, company’s management has to divide total fixed costs by the contribution margin per unit. As a result, they will get the minimum required sales volume under which net profit will be equal to zero. That means that company will receive positive net profits after it starts producing more than the break-even point.
We may demonstrate the break-even analysis with the example:
We first calculate a contribution margin from each unit sold. CM = 100 – 30 – 25 - 10 – 10 = $25. We now see that revenue from each unit sold is greater than costs associated with its production. Thus, in order to calculate the break-even point we need to find out how many units we need to produce in order to cover all fixed costs. Total fixed costs equal 50,000 + 60,000 = $110,000. We now divide total fixed costs by contribution margin: 110,000/25 = 4400. Thus, we need to produce and sell at least 4400 units in order for profits to be equal to zero. Any additional unit sold after 4400 will contribute $25 to net profits.
Ross, S. A., et al. 2010. Fundamentals of corporate finance. Sixth Edition. McGraw Hill.
Brealey, R. A., Myers, S. C., & Marcus, A. J. 2001. Fundamentals of Corporate Finance. Third Edition. The McGraw-Hill.
Gibson, C. H., 2012. Financial Reporting and Analysis, 13th edition. Cengage Learning.
Giddy, I. H., 1983. The International Finance Handbook. Wiley Press.