¶ … Income Statement
Contribution Method
Revenue
$5,985,000
$5,985,000
Variable mfg cost
$1,543,500
Variable op cost
$414,000
Total Variable cost
$1,957,500
$1,957,500
Contribution
$4,027,500
Fixed Costs
Mfg Overhead
$1,600,000
$1,200,000
Total Fixed Costs
$2,800,000
$2,800,000
Net Profit
$1,227,500
Absorption Method
Revenue
$6,555,000
COGS
$1,690,500
Operating Expense
$2,014,000
S&A Expense
$1,200,000
Net Income
$1,650,500
The main difference between the contribution method is that it factors in the cost of goods sold for the goods produced that year. Production costs factor in the inventory at the beginning and end of the period. This makes the contribution margin approach valuable from a management accounting perspective because it provides more direct insight into the cost structure of the year's revenues.
The absorption method is more suitable for financial accounting. The method is valuable because it outlines the year's activities. The cost of goods sold includes the cost of the beginning inventory, but not the cost of the ending inventory. This is more in line with GAAP than is contribution margin.
We can see that one of the most significant differences is that the contribution margin method gives a different profit for the period compared with the absorption method. This is the result of the decline in inventory levels. If the inventory levels had not changed, there would have been no difference between the net profit for the two methods.
If the company sold another 10,000 units, it would have a higher profit. This calculation was based on the contribution margin method. What occurs in this method is that the company sells more, but it does not produce more. Therefore, the variable operating and selling cost increases, but the variable production cost does not increase. The inventory is run down further than in the first example, increasing the spread between the profit in the two methods.
I would recommend to management that the absorption method is used to calculate these costs. Because the costs are matched up more closely with sales, the resulting figures give management a better figure of the cost of the goods sold for the year. This reduces the impact that management can have on the results, which could under the contribution margin method be subject to managerial manipulation through manipulation of production levels at the end of one period, which would lower the cost at the beginning of the next.
