Absorption Income versus Contribution Margin Income
Absorption Income versus Contribution Margin Income
Given the computations for both gross profit on sales and contribution margin, can you give specific benefits to be derived from gross profit on sales as opposed to contribution margin? Is net income always going to be the same regardless of the accounting approach?
Let me give you a simple example. Look at the income statements below before you answer the questions.
ABC Company sells 10,000 widgets. The company has no beginning or ending inventory. Using the absorption approach (GAAP) the net income of the company is as follows:
Sales (10,000 @ $20) $200,000
Cost of goods sold (10,000 @ $12) 120,000
Gross profit $ 80,000
Expenses 20,000
Net income $ 60,000
Using the contribution margin approach the net income of the company is as follows:
Sales (10,000 @ $20) $200,000
Variable cost of goods sold (10,000 @ $8) 80,000
Gross profit $120,000
Fixed expenses 60,000
Net income $ 60,000
Absorption Income and Contribution Margin Income are two different approaches to calculating income in managerial accounting. They have distinct benefits and implications.
Absorption Income is calculated by subtracting all manufacturing costs, including both variable and fixed costs, from sales revenue. It takes into account all costs involved in producing the goods or services, including those that are fixed and do not vary with the level of production. In the example you provided, the absorption income is $60,000.
On the other hand, Contribution Margin Income is calculated by subtracting only the variable costs from sales revenue. It focuses solely on the costs that vary with the level of production and excludes fixed costs. In the example you provided, the contribution margin income is also $60,000.
Now, let's discuss the specific benefits of using gross profit on sales (absorption income) compared to contribution margin income:
1. Reflects the full cost of production: Absorption Income considers all manufacturing costs, including fixed costs that are necessary for production. This provides a more comprehensive view of the overall expenses involved and allows managers to determine whether the current pricing strategy is covering all costs.
2. Compliance with GAAP: Absorption Income follows the Generally Accepted Accounting Principles (GAAP), which is the standard accounting framework used in the United States. This ensures consistency and comparability of financial statements across companies and allows for better decision-making by following industry standards.
3. Better suited for external reporting: Absorption Income is typically used for external financial reporting, such as preparing financial statements for stakeholders, lenders, and investors. It provides a clearer picture of the company's financial performance and profitability to external parties.
Regarding your question about net income being the same regardless of the accounting approach, the answer is not always. In the example you provided, both approaches yield the same net income of $60,000. However, this is not always the case. Net income can vary depending on the level of fixed costs, volume of sales, and the relationship between variable costs and fixed costs.
In summary, Absorption Income and Contribution Margin Income have their own advantages, and the choice of which approach to use depends on the purpose of the analysis and the audience. While absorption income gives a comprehensive view of costs and is suitable for external reporting, contribution margin income focuses on variable costs and is useful for internal decision-making. Net income can differ between the two approaches depending on the specific circumstances.
The two approaches, absorption income and contribution margin income, differ in the way they allocate fixed manufacturing overhead costs.
In absorption income, fixed manufacturing overhead costs are allocated to the cost of goods sold and are included in the calculation of gross profit. This means that a portion of fixed manufacturing overhead costs is included in the cost of each unit sold. In the example given, the absorption approach resulted in a gross profit of $80,000.
On the other hand, contribution margin income does not allocate fixed manufacturing overhead costs to the cost of goods sold. Instead, fixed manufacturing overhead costs are treated as a period cost and are deducted separately from the contribution margin. In the example given, the contribution margin approach resulted in a higher gross profit of $120,000, as the fixed manufacturing overhead costs are not included in the calculation.
The benefit of using gross profit on sales (absorption income) is that it reflects the full cost of producing and selling a product, including both variable and fixed costs. It provides a more complete picture of the profitability of each unit sold.
On the other hand, the benefit of using contribution margin income is that it simplifies the analysis of the financial performance by separating fixed costs from variable costs. This approach helps managers in making short-term decisions as it focuses on the contribution margin, which represents the amount available to cover fixed costs and provide a contribution towards covering the company's other expenses.
Regarding net income, it will be the same regardless of the accounting approach if all costs are correctly classified and allocated. In the given example, both approaches resulted in the same net income of $60,000. However, this may not always be the case if there are differences in cost allocation or classification between the approaches.