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, we need to understand the key differences between these two approaches.
Variable (Contribution Margin) Costing:
In variable costing, only variable manufacturing costs are included in the cost of the product. Fixed manufacturing overhead costs are treated as period expenses and are not included in the cost of the product. This means that fixed manufacturing overhead costs are expensed in the period they are incurred.
Steps to prepare the income statement using variable costing:
1. Calculate the total variable manufacturing cost per unit by summing the direct materials cost and direct labor cost per unit.
Variable manufacturing cost per unit = $3.50 + $1.40 = $4.90
2. Calculate the total variable operating/selling cost per unit sold.
Variable operating/selling cost per unit sold = $1.20
3. Calculate the total variable cost per unit sold by summing the total variable manufacturing cost and total variable operating/selling cost per unit sold.
Total variable cost per unit sold = $4.90 + $1.20 = $6.10
4. Calculate the total variable cost of goods sold by multiplying the total variable cost per unit sold by the number of units sold.
Total variable cost of goods sold = $6.10 * 345,000 units
5. Calculate the contribution margin by subtracting the total variable cost of goods sold from the total sales.
Contribution margin = Total sales - Total variable cost of goods sold
6. Calculate the gross profit by subtracting the total variable operating/selling cost per unit sold from the contribution margin.
Gross profit = Contribution margin - (Total variable operating/selling cost per unit sold * Number of units sold)
7. Calculate the operating (net) income by subtracting the fixed selling & administrative expenses from the gross profit.
Operating (net) income = Gross profit - Fixed selling & administrative expenses
Traditional (Absorption) Costing:
In absorption costing, both variable and fixed manufacturing costs are included in the cost of the product. Fixed manufacturing overhead costs are allocated to the units produced based on a predetermined overhead rate. This means that fixed manufacturing overhead costs are capitalized as part of the inventory and expensed when the inventory is sold.
Steps to prepare the income statement using absorption costing:
1. Calculate the predetermined overhead rate by dividing the total fixed manufacturing overhead costs by the total number of units (production capacity).
Predetermined overhead rate = Total fixed manufacturing overhead costs / Production capacity
2. Calculate the fixed manufacturing overhead cost per unit by multiplying the predetermined overhead rate by the number of units produced.
Fixed manufacturing overhead cost per unit = Predetermined overhead rate * (Number of units produced + Beginning inventory - Ending inventory)
3. Calculate the total cost per unit by summing the variable manufacturing cost per unit and the fixed manufacturing overhead cost per unit.
Total cost per unit = Variable manufacturing cost per unit + Fixed manufacturing overhead cost per unit
4. Calculate the total cost of goods sold by multiplying the total cost per unit by the number of units sold.
Total cost of goods sold = Total cost per unit * Number of units sold
5. Calculate the gross profit by subtracting the total cost of goods sold from the total sales.
Gross profit = Total sales - Total cost of goods sold
6. Calculate the operating (net) income by subtracting the fixed selling & administrative expenses from the gross profit.
Operating (net) income = Gross profit - Fixed selling & administrative expenses
Now, let's calculate the required values:
1. Prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 2009, using the steps explained above.
Variable (Contribution Margin) Costing Income Statement:
Sales revenue $ (Total sales * Selling price per unit)
- Variable cost of goods sold $ (Total variable cost of goods sold)
= Contribution margin $ (Contribution margin = Sales - Variable cost of goods sold)
- Fixed selling & administrative expenses $ (Fixed selling & administrative expenses)
= Operating (net) income $ (Operating (net) income = Contribution margin - Fixed selling & administrative expenses)
Traditional (Absorption) Costing Income Statement:
Sales revenue $ (Total sales * Selling price per unit)
- Cost of goods sold $ (Total cost of goods sold)
= Gross profit $ (Gross profit = Sales - Cost of goods sold)
- Fixed selling & administrative expenses $ (Fixed selling & administrative expenses)
= Operating (net) income $ (Operating (net) income = Gross profit - Fixed selling & administrative expenses)
2. To calculate E's contribution margin ratio, gross profit ratio, and operating (net) income ratios, you will need the following formulas:
Contribution margin ratio = (Contribution margin / Sales) * 100
Gross profit ratio = (Gross profit / Sales) * 100
Operating (net) income ratio = (Operating (net) income / Sales) * 100
Plug in the values from the respective income statements for each ratio to calculate them.