Both the traditional and the contribution margin income statements are used to show and communicate the company’s financial revenues, expenses as well as the profits that are generated during a certain financial accounting period. The most important thing in deriving these two types of income statements is the revenue generated during a certain period and the expenses incurred during the same period. The only difference between the two types of the statements is the derivation process of the net income and the interpretation of the two types of statements.
The contribution margin income statement has a place for showing both the fixed and the variable costs of a company. There are some cases where the operating profits of a company be the same when the two procedures are used. The only difference may only be in the format and the arrangement of the data in both cases. The organization of the data in a contribution margin income statement is such that it becomes easier for the management to make a follow up and know the production capacity. Moreover, the manager can be able to establish what part of amount of production does affect the profitability of the company. The contribution margin of the company shown in the income statement represents the amount of sales revenue that remains after the variable cost has been deducted from sales. The contribution margin in this case is what remains as a contribution in covering the fixed costs and the operating profits of the company.
The traditional income statement uses the full absorption where both the fixed and the variable costs of the company are all treated as a part of the inventory. It therefore means that the two factors will all fall in the brackets of the cost of goods sold. On the contrary, the contribution margin uses the variable costing method where the manufacturing costs forms part of the overhead cost of that accounting period. The fixed and manufacturing costs therefore do not form part of the product costs. The major reason behind the concept is that companies would always incur expenses even if they do not make any sales volumes during a certain period. Since it is believed that the fixed cost will always be incurred, it is appropriate for the costs not to be included in the product costs.
The function of the contribution margin is to help the administrators and the relevant stakeholders to know the break-even point of a company’s specific product or even a combination of products. The break-even point can be defined as the sales volume at which the company is able to recover the fixed expenses. Moreover, it is at the break-even point that the company will always begin making financial profits. In most cases, it is the manufacturing operations that stand to benefit whenever the contribution margin format is used.
Using the information given, the two set of income statements would appear as follows:
Traditional ($)
Sales 10, 000, 000
Less cost of goods sold 8, 000, 000
Less fixed and variable expenses 2, 000, 000
Net profits 0
Contribution margin
Sales ` 10, 000, 000
Less variable costs of goods sold 6, 000, 000
Gross contribution margin 4, 000, 000
Less variable marketing and administrative expenses 1, 000, 000
Contribution margin 3, 000, 000
Less fixed expenses 1, 000, 000
Net profit 2, 000, 000
When the managements decide to use the contribution margin, chances are so high that the value of the profits will be higher than the case when they use the traditional method. That explanation can be clearly illustrated using the above example. We can already see that the net profit for the company was zero when we used the traditional method. On the contrary, when we used the contribution margin merhod, the net profits for the company increased to a new value of $ 2, 000, 000. If the sales increased, for imntsance with a value of 20%, the net profits for the company will also increase as shown by the calculations below:
Sales 12, 000, 000
Less variable costs of goods sold 7,200,000
Gross contribution margin 4, 800, 000
Less variables marketing and administrative expenses 1, 200, 000
Contribution margin 3, 600, 000
Less fixed expenses 1, 000, 000
Net profit 2, 600, 000
The calculations therefore already show that there will be high chances of an increase in profits if indeed the sales were to increase with a value of 20%. Therefore for the project profits, it is important that the calculations be done using the contribution margin process rather than using the traditional approach.
If we use the data where the sales increased by a margin of 10%, the value of the profits will as follows:
Sales 11, 000, 000
Less variable costs of goods sold 5,500,000
Gross contribution margin 5, 500, 000
Less variables marketing and administrative expenses 1, 200, 000
Contribution margin 4, 300, 000
Less fixed expenses 2, 000, 000
Net profit 2, 300, 000
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