Explain the difference between the two types of income statements.
• Prepare absorption and contribution margin income statements for the
succeeding quarter for the division.
• Compute production costs per unit for both approaches and for both quarters.
• Discuss three shortcomings of the absorption approach for internal decision-
Contribution and absorption income statement
Fixed costs are firm’s expenditure that is unrelated or dependent on the amount of items or
services produced by the company. They include overhead expenditure and other indirect
expenses of business. They tend to be related to time such as wages, security, marketing,
administrative expenses or even monthly or quarterly rent payment. Fixed expenses or other
costs are used to control and maintain the prices of items or services to maximize the profits to
ensure appropriate income and profitability for the investment made.
Variable costs or expenses are costs that change in proportion to the activities or operations of
the company or business. Labor and other overheads, conversion expenses or other related cost
as they are referred to. Prime cost is a variable cost and it includes 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)
- Mr. Rosen performance in the second quarter indicates that in the net income was $1,250,000
while in the first quarter it was $350,000 under absorption income statement while under the
contribution income statement it was $950,000 in the second quarter. The performance of Mr.
Rosen improved only in its manufacturing department which doubled its output while the sales
department didn’t improve only the method of valuing stock was changed. The optimum
production capacity for the Jokkmok ltd was utilized to produce the maximum units.
- 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)
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,
- Mr. Rosen should be considered as the CEO as he has tried to maximize his production and
also to maintain his sales to be at least 50% of the total manufactured goods. The cost of
production is very high but the net income for the second quarter improved though it was related
to the change in valuation method.
- 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
To conclude, most costing methods are based and rely on financial costing systems and are
therefore unsuitable for critical decision making purposes. Only the production overhead costs
can be absorbed into the cost of the product for reasons of inventory valuation, while ignoring
the administrative expenses.
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.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007) Intermediate Accounting (12th Ed.).
Hoboken, NJ: John Wiley & Sons,
Khan, M. (1993) Theory & Problems in Financial Management. Boston: McGraw Hill