Skills to Develop
- Prepare a contribution margin income statement.
After further work with her staff, Susan was able to break down the selling and administrative costs into their variable and fixed components. (This process is the same as the one we discussed earlier for production costs.) Susan then established the cost equations shown in Table 5.5.
|Production costs||Y = $43,276 + $53.42X|
|Selling and administrative costs||Y = $110,000 + $9.00X|
Question: The challenge now is to organize this information in a way that is helpful to management—specifically, to Eric Mendez. The traditional income statement format used for external financial reporting simply breaks costs down by functional area: cost of goods sold and selling and administrative costs. It does not show fixed and variable costs. Panel A of Figure 5.7 illustrates the traditional format. (We defer consideration of income taxes to the end of Chapter 6.) How can this information be presented in an income statement that shows fixed and variable costs separately?
Another income statement format, called the contribution margin income statement11 shows the fixed and variable components of cost information. This type of statement appears in panel B of Figure 5.7. Note that operating profit is the same in both statements, but the organization of data differs. The contribution margin income statement organizes the data in a way that makes it easier for management to assess how changes in production and sales will affect operating profit. The contribution margin12 represents sales revenue left over after deducting variable costs from sales. It is the amount remaining that will contribute to covering fixed costs and to operating profit (hence, the name contribution margin).
Eric indicated that sales volume in August could increase by 20 percent over sales in June of 5,000 units, which would increase unit sales to 6,000 units [= 5,000 units + (5,000 × 20 percent)], and he asked Susan to come up with projected profit for August. Eric also mentioned that the sales price would remain the same at $100 per unit. Using this information and the cost estimate equations in Table 5.5, Susan prepared the contribution margin income statement in panel B of Figure 5.7. Assume for now that 6,000 units is just within the relevant range for Bikes Unlimited. (We will discuss this assumption later in the chapter.)
Figure 5.7 - Traditional and Contribution Margin Income Statements for Bikes Unlimited
*From Table 5.5
The contribution margin income statement shown in panel B of Figure 5.7 clearly indicates which costs are variable and which are fixed. Recall that the variable cost per unit remains constant, and variable costs in total change in proportion to changes in activity. Because 6,000 units are expected to be sold in August, total variable costs are calculated by multiplying 6,000 units by the cost per unit ($53.42 per unit for cost of goods sold, and $9.00 per unit for selling and administrative costs). Thus total variable cost of goods sold is $320,520, and total variable selling and administrative costs are $54,000. These two amounts are combined to calculate total variable costs of $374,520, as shown in panel B of Figure 5.7.
The contribution margin of $225,480 represents the sales revenue left over after deducting variable costs from sales ($225,480 = $600,000 − $374,520). It is the amount remaining that will contribute to covering fixed costs and to operating profit.
Recall that total fixed costs remain constant regardless of the level of activity. Thus fixed cost of goods sold remains at $43,276, and fixed selling and administrative costs stay at $110,000. This holds true at both the 5,000 unit level of activity for June, and the 6,000 unit level of activity projected for August. Total fixed costs of $153,276 (= $43,276 + $110,000) are deducted from the contribution margin to calculate operating profit of $72,204.
Armed with this information, Susan meets with Eric the next day. Refer to panel B of Figure 5.7 as you read Susan’s comments about the contribution margin income statement.
|Susan:||Eric, I have some numbers for you. My projection for August is complete, and I expect profit to be approximately $72,000 if sales volume increases 20 percent.|
|Eric:||Excellent! You were correct in figuring that profit would increase at a higher rate than sales because of our fixed costs.|
|Susan:||Here’s a copy of our projected income for August. This income statement format provides the variable and fixed costs. As you can see, our monthly fixed costs total approximately $153,000. Now that we have this information, we can easily make projections for different scenarios.|
|Eric:||This will be very helpful in making projections for future months. I’ll take your August projections to the management group this afternoon. Thanks for your help!|
Business in Action 5.3
Costs at Lowe’s Companies, Inc
Lowe’s is the world’s second largest home improvement retailer with more than 1,700 stores in the United States, Canada, and Mexico. The company has 234,000 employees. The following financial information is from Lowe’s income statement for the year ended January 28, 2011 (amounts are in millions). Which of the company’s costs are likely to be variable?
Variable costs probably include cost of sales (the cost of goods sold) and a portion of selling and general and administrative costs (e.g., the cost of hourly labor). Cost of sales alone represents 65 percent of net sales (rounded). Retail companies like Lowe’s tend to have higher variable costs than manufacturing companies like General Motors and Boeing.
Source: Lowe’s Web site (http://www.lowes.com).
The contribution margin income statement shows fixed and variable components of cost information. Revenue minus variable costs equals the contribution margin. The contribution margin minus fixed costs equals operating profit. This statement provides a clearer picture of which costs change and which costs remain the same with changes in levels of activity.
REVIEW PROBLEM 5.7
Last month, Alta Production, Inc., sold its product for $2,500 per unit. Fixed production costs were $3,000, and variable production costs amounted to $1,400 per unit. Fixed selling and administrative costs totaled $50,000, and variable selling and administrative costs amounted to $200 per unit. Alta Production produced and sold 400 units last month.
Prepare a traditional income statement and a contribution margin income statement for Alta Production. Use Figure 5.7 as a guide.
- An income statement used for internal reporting that shows fixed and variable cost information.
- Sales revenue left over after deducting variable costs from sales.