The E-Company
The E-Company manufactures trendy, high-quality moderately priced watches that it sells on the Internet. As the company's senior financial analyst, you are asked to analyze the overall profitability fo the current year. The CFO has heard that there are two different approaches for preparing income statment.s You are asked to show the CFO both approaches and explain the advantages or disadvantes of each method. The following data are for the year ended December 31, 2009:
Production capacity is 400,000 units
Beginning inventory, January 1: 85,000 units
Ending inventory, December 31: 55,000 units
Sales for the year are: 345,000 units
Selling price (to distributor) $19.00 per unit
Variable manufacturing cost per unit, including direct materials of $3.50 and direct labor of $1.40
Variable operating/selling cost per unit sold $1.20
Fixed manufacturing overhead $1,600,000
Fixed sellling & administrative expenses $1,200,000
Assume costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume the prices and unit costs did not change during the year.
Requirement:
1. Prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 2008.
2. What are E's contribution margin ratio, gross profit ratio and operating (net) income ratios?
To prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 2009, you will need to calculate the relevant figures based on the given data.
1. Variable (Contribution Margin) Costing Income Statement:
Under variable costing, only variable costs are considered as product costs. Fixed manufacturing overhead costs are treated as period costs and are expensed in the period they are incurred. The income statement will be as follows:
Sales revenue: 345,000 units x $19.00 per unit = $6,555,000
Variable manufacturing costs: 345,000 units x ($3.50 + $1.40) per unit = $1,587,750
Variable operating/selling costs: 345,000 units x $1.20 per unit = $414,000
Contribution Margin: Sales Revenue - Variable Costs = $6,555,000 - ($1,587,750 + $414,000) = $4,553,250
Fixed selling & administrative expenses: $1,200,000
Operating (Net) Income: Contribution Margin - Fixed Selling & Administrative Expenses = $4,553,250 - $1,200,000 = $3,353,250
2. Traditional (Absorption) Costing Income Statement:
Under absorption costing, both variable and fixed manufacturing costs are considered as product costs and are included in the cost of goods sold. The income statement will be as follows:
Sales revenue: $6,555,000
Cost of goods sold: (Beginning inventory + Units produced) * (Variable manufacturing cost + Fixed manufacturing overhead) = (85,000 + 345,000) * (($3.50 + $1.40) + ($1,600,000 / 400,000)) = $2,747,500
Gross Profit: Sales Revenue - Cost of Goods Sold = $6,555,000 - $2,747,500 = $3,807,500
Selling & Administrative expenses: $1,200,000
Operating (Net) Income: Gross Profit - Selling & Administrative expenses = $3,807,500 - $1,200,000 = $2,607,500
Now, let's move on to the second requirement:
2. Contribution Margin Ratio, Gross Profit Ratio, and Operating (Net) Income Ratio:
- Contribution Margin Ratio is calculated by dividing the Contribution Margin by the Sales Revenue.
Contribution Margin Ratio = (Contribution Margin / Sales Revenue) * 100
- Gross Profit Ratio is calculated by dividing the Gross Profit by the Sales Revenue.
Gross Profit Ratio = (Gross Profit / Sales Revenue) * 100
- Operating (Net) Income Ratio is calculated by dividing the Operating (Net) Income by the Sales Revenue.
Operating (Net) Income Ratio = (Operating (Net) Income / Sales Revenue) * 100
Using the calculated figures from the income statements:
Contribution Margin Ratio = (4,553,250 / 6,555,000) * 100 = 69.49%
Gross Profit Ratio = (3,807,500 / 6,555,000) * 100 = 58.09%
Operating (Net) Income Ratio = (2,607,500 / 6,555,000) * 100 = 39.80%
These ratios represent the company's profitability and can be used to analyze the company's performance.