Variable and Fixed Costs



Variable and Fixed Costs

Variable and Fixed Costs

SLP Module 1

Contribution Margin Income Statement

The contribution margin format of Herrestad Company starts with revenue as the top line. However, instead of showing cost of goods and operating expenses, a contribution margin statement breaks out the variable and fixed expenses separately. Variable expenses include variable production costs, such as raw materials and direct labor, and variable marketing and administrative expenses, such as commission expenses and the salaries of supervisors. The contribution margin is the difference between revenues and variable expenses. The next section shows the fixed production and overhead costs, such as building and equipment maintenance costs, insurance and administration. The net income is the difference between the contribution margin and the fixed expenses (Horngren, 2012).

The contribution margin format uses variable costing, in which fixed manufacturing costs are part of the overhead costs of the accounting period and are not part of the product costs. The reasoning behind this approach is that because companies incur these fixed costs regardless of the sales volume, they should not be a part of product costs. A traditional income statement shows the gross profit, operating profit and pretax and after-tax net income for an accounting period. Generally accepted accounting principles require companies to use the traditional income statement format for external reporting. The contribution margin format allows stakeholders to determine the breakeven point of individual products or product categories. The breakeven point is the sales level at which the company covers its fixed expenses and begins to make a profit. Manufacturing operations benefit from the contribution margin format.

For the Herrestad Company, the contribution margin equals variable expenses minus total revenue.

Herrestad Company

Contribution Margin Income Statement (At Selling Price = $250)

For the period ending Dec. 31, 2011

Sales (8000units * $250)

$2,000,000.00

Less: Variable Costs

1,520,000.00

Contribution Margin

$480,000.00

Less: Fixed manufacturing overhead

200,000.00

Less: Fixed selling and administrative

100,000.00

Net Profit

$180,000.00

At the selling price of $250, the company is generating less net income due to the reasons of high variable costs, which ultimately results in lower contribution margin. On the other hand, the fixed costs are also at high a level, which reduces the profitability of the company.

Herrestad Company

Contribution Margin Income Statement (At Selling Price = $280)

For the period ending Dec. 31, 2011

Sales

$2,240,000.00

Less: Variable Costs

1,520,000.00

Contribution Margin

$720,000.00

Less: Fixed manufacturing overhead

200,000.00

Less: Fixed selling and administrative

100,000.00

Net Profit

$420,000.00

At the selling price of $280, the company is generating higher net income due to the reasons of stable variable costs, which ultimately results in high contribution margin. On the other hand, the fixed costs are stable and it has not changed due to the changing selling price, which improves the profitability of the company.

Since, in this case scenario the all the financial information of the Herrestad Company has remains the same except the selling price which has improved in this case. The positive change in the selling price has impacted the company positively in terms of higher contribution margin and net profit.

Break Even Analysis for the Herrestad Company

One of the primary uses of the contribution income statement ...