Your general manager called you into his office to discuss an ongoing problem. He explains that in the past, whenever he wanted to know how the projected income statement might change if sales volume changes, it would take weeks to have the accounting department redo the entire budget. You try to hide your smile, as you had discussed this very kind of problem in your accounting class the prior evening. You tell him that the easy solution to this planning problem is to change from the traditional income statement format to the contribution format income statement. Using the contribution format will dramatically reduce the time it will take to do a what-if analysis (how profits may change if sales volume goes up or down from the current budget.)
Explain what you would have to do to project profits using the traditional format if sales were to increase 20%.
Explain how and why it would be easier if the contribution format were used.
Describe the steps needed to create a contribution format income statement.
Include 1 data slide and examples of a traditional format income statement and the equivalent contribution format, based on that data.
Use charts when appropriate to make it visually interesting
Can someone please explain this to me?
do not know. can someone help?
To project profits using the traditional format when sales increase by 20%, you would need to go through multiple steps. Here's a breakdown of the process:
1. Gather information: Obtain the current budgeted income statement, which includes details of revenues, expenses, and profit.
2. Determine the sales increase: Calculate the 20% increase in sales volume by multiplying the current sales figure by 1.20.
3. Adjust the revenue: Increase the sales revenue figure by the calculated sales increase.
4. Evaluate cost changes: Identify the variable costs that are directly linked to sales volume and adjust them according to the sales increase percentage. For example, if the cost of goods sold is generally 60% of sales, you would increase this amount by 20%.
5. Analyze fixed costs: Determine which fixed costs might be affected by the sales increase. If any fixed costs are expected to change, adjust them accordingly.
6. Recalculate profit: Subtract the adjusted variable and fixed costs from the adjusted revenue to obtain the projected profit.
While this method would eventually yield the desired information, it can be time-consuming and cumbersome, as it requires adjusting multiple line items manually. This is where the contribution format income statement comes in to offer a simpler and more efficient solution.
Using the contribution format income statement makes the analysis easier for the following reasons:
1. Separates costs by behavior: The contribution format separates costs into fixed and variable categories, making it easier to identify which costs will be affected by changes in sales volume.
2. Focuses on contribution margin: The contribution margin is the difference between sales revenue and variable costs. By using this format, you can focus on the contribution margin per unit or as a percentage of sales, which helps in analyzing the impact of changes in sales volume on profit.
3. Eliminates allocation of fixed costs: Unlike the traditional format, which allocates fixed costs across multiple line items, the contribution format treats fixed costs as a lump sum deducted from the contribution margin. This simplifies the analysis and allows for quicker what-if scenarios.
Steps to create a contribution format income statement:
1. Identify variable costs: Determine the costs that vary with changes in sales volume, such as direct materials, direct labor, and variable overhead.
2. Calculate contribution margin: Subtract the total variable costs from sales revenue to obtain the contribution margin.
3. Determine fixed costs: Identify the costs that remain unchanged regardless of sales volume, such as rent, salaries, and insurance.
4. Calculate the contribution margin ratio: Divide the contribution margin by sales revenue to obtain the contribution margin ratio (%).
5. Deduct fixed costs: Subtract the fixed costs from the contribution margin to obtain the operating profit.
Here's an example showcasing a traditional format income statement and the equivalent contribution format:
Traditional Format Income Statement:
| | Sales Revenue | Cost of Goods Sold | Gross Profit | Operating Expenses | Net Profit |
|------------|---------------|-------------------|--------------|--------------------|------------|
| Current | $1,000,000 | $600,000 | $400,000 | $200,000 | $200,000 |
| Projected | $1,200,000 | $720,000 | $480,000 | $200,000 | $280,000 |
Contribution Format Income Statement:
| | Sales Revenue | Variable Costs | Contribution Margin | Fixed Costs | Operating Profit |
|------------|---------------|----------------|---------------------|-------------|------------------|
| Current | $1,000,000 | $600,000 | $400,000 | $200,000 | $200,000 |
| Projected | $1,200,000 | $720,000 | $480,000 | $200,000 | $280,000 |
By using the contribution format, it becomes easier to understand the impact of changes in sales volume on profit as you focus on the contribution margin and its relationship with fixed costs. The separation of costs by behavior simplifies the what-if analysis and allows for quicker decision-making.