Contribution and absorption income statement
Introduction
Fixed costs are firm’s expenses that are not related or dependent on the level of
quantity of items or services produced by the company. They include overhead and other indirect
expenses of operating a company. They tend to be periodical or time-related such as salaries,
security, marketing, administrative supplies or even rent payable monthly or quarterly. Fixed
expenses or costs are used to control the prices of products or services to maximize profits to
ensure appropriate returns and profitability the investment made. Variable costs are costs that
vary in proportion to the activities of a company or business. For example direct labor and
overheads or conversion cost as they are referred to. Also the prime cost is also a variable cost
i.e. direct labor and direct material. Traditional costing concepts separate and split costs between
fixed and variable. The time scales that are relevant and applicable to most major projects make
this method of costing unsuitable and redundant. Costs are normally classified in terms of short
or long run since most strategic decisions are meant to cover between three to five years during
which period some costs turn and become variable. (Garrison, Noreen, Brewer, 2009)
Explain the main differences between the absorption and contribution (behavioral, variable)
income statements.
The contribution income statement involves only the variable costs in its calculations of the
contribution and the cost of sales and transfers most of the values of the closing stock to later
2 Accounting
dates while the absorption income statement involves part of the fixed costs and the variable
costs in its determination of the closing stock in its cost of sales. (Kieso, Weygandt & Warfield,
2007) Absorption costing apportions all the overheads to the individual products. In order to
achieve this, the companies must directly apportion and allocate each service overhead to the
major production department. All the direct labor/machine hourly rates are then calculated. All
the costs are allocated to various individual departments and it’s assumed that the overhead costs
relate directly and precisely to the level of production. The major problem with this concept is
that the allocation or the apportionment of the costs is done arbitrary and may not give an
accurate view of the activities which are responsible for the costs. A certain product or an
activity may show a big loss just because the method used to allocate the costs have changed.
Absorption costing is time consuming and requires a lot of concentration and energy to
determine and implement an accurate basis of overall overhead allocation and eventual
apportionment.
Will net income always be the same under the two approaches? If not, explain the difference.
Comment specifically on why companies feel the need to create yet another income statement
in a different format.
The net income between the contribution income statement and the absorption income
statement can never be the same. The absorption income statement utilizes both the variable
expenses and the fixed expenses when determining the closing stock while computing the cost
of sales. The contribution income statement only utilizes the variable cost while calculating its
contribution margin and the cost of sales and it completely ignores the fixed expenses. The
need for companies to create another income statement comes in because of the calculation of
the closing stock on rates that are similar to the current rates of the sales to give a true and fair
view of the cost of sales. (Khan, 1993)
3 Accounting
What information can the company gleam from this approach which is helpful as a tool in the
decision making process.
The most important information from the above argument a company can utilize as a tool in
decision making process is the valuation of closing stock and the way the different methods of
absorption and contribution income statements affect the net income. The absorption income
statement valuation of the closing stock utilizes most of the cost in the current income statement
by also including the fixed costs together with the variable costs i.e. it’s very realistic while
contribution income only uses the variable cost while determining the closing stock and it
excludes the fixed costs.( Drucker, 1999)
Explain situations in which break-even analysis can be a useful tool. Provide a specific example.
Breakeven analysis is the point where the total revenues of the product sales are equal to the
total of all the costs associated with the sale of the product. In simple terms the profit is zero i.e.
profit = 0. Breakeven analysis is a useful tool when it comes to planning and controlling the
business operations. The breakeven point gives a true representation of the volume of the firm’s
business. It shows whether the total revenue from a service or product has the capability to
cover all the costs of the production of the product or service. It’s critical during the initial
planning of a business as it shows the minimum number of units to be produced in order for the
business to remain afloat. The resources the firm requires for its startup can then be calculated.
For instance, when the business is planning its marketing strategy the amount of sales or the
volume of sales the market can absorb or the size of market the company requires can be
estimated from the breakeven analysis. When businesses and companies expand and grow over
a certain period of time, the nature of their transactions progressively become more complex.
The costs incurred due to the complexity of businesses vary. A business that produces for
instance a hundred complex and sophisticated items will need advanced support functions than a
4 Accounting
business that produces one or two simple items. Breakeven analysis plays a big role in the
determination of the estimated volume of sales for complex business operations.
References
Drucker, F. (1999) Management Challenges of the 21st Century. New York: Harper Business,
Garrison, H., Noreen, E., Brewer, C. (2009) Managerial Accounting . McGraw-Hill Irwin.
2009.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007) Intermediate Accounting (12th Ed.).
Hoboken, NJ: John Wiley & Sons,
Khan, M. Theory & Problems in Financial Management. (1993) Boston: McGraw Hill
Higher Education.
