After further work with her staff, Susan was able to break down the selling and administrative costs into their variable and fixed components. (This process is the same as the one we discussed earlier for production costs.) Susan then established the cost equations shown in Table 5.5 “Cost Equations for Bikes Unlimited”.
Table 5.5 Cost Equations for Bikes Unlimited
Y = $43,276 + $53.42X
Selling and administrative costs
Y = $110,000 + $9.00X
Question: The challenge now is to organize this information in a way that is helpful to management—specifically, to Eric Mendez. The traditional income statement format used for external financial reporting simply breaks costs down by functional area: cost of goods sold and selling and administrative costs. It does not show fixed and variable costs. Panel A of Figure 5.7 “Traditional and Contribution Margin Income Statements for Bikes Unlimited” illustrates the traditional format. (We defer consideration of income taxes to the end of Chapter 6 “How Is Cost-Volume-Profit Analysis Used for Decision Making?”.) How can this information be presented in an income statement that shows fixed and variable costs separately?
Answer: Another income statement format, called the contribution margin income statement, shows the fixed and variable components of cost information. This type of statement appears in panel B of Figure 5.7 “Traditional and Contribution Margin Income Statements for Bikes Unlimited”. Note that operating profit is the same in both statements, but the organization of data differs. The contribution margin income statement organizes the data in a way that makes it easier for management to assess how changes in production and sales will affect operating profit. The contribution margin represents sales revenue left over after deducting variable costs from sales. It is the amount remaining that will contribute to covering fixed costs and to operating profit (hence, the name contribution margin).
Eric indicated that sales volume in August could increase by 20 percent over sales in June of 5,000 units, which would increase unit sales to 6,000 units [= 5,000 units + (5,000 × 20 percent)], and he asked Susan to come up with projected profit for August. Eric also mentioned that the sales price would remain the same at $100 per unit. Using this information and the cost estimate equations in Table 5.5 “Cost Equations for Bikes Unlimited”, Susan prepared the contribution margin income statement in panel B of Figure 5.7 “Traditional and Contribution Margin Income Statements for Bikes Unlimited”. Assume for now that 6,000 units is just within the relevant range for Bikes Unlimited. (We will discuss this assumption later in the chapter.)