# Jokkmokk Industries: Absorption and Contribution Margin Income Statements

## Introduction

The absorption accounting method involves the generalization of fixed costs and variable cost when calculating gross profit. Mingxinlu (2009) explains that mixed costs have a variable component, and a fixed component. The value of the fixed costs may not be known unless additional information is provided after the financial statement. Variable cost accounting emphasizes the separation of the variable costs of production in calculating the contribution margin. Absorption accounting is required through the generally accepted accounting principle (GAAP) for external financial reporting (accountingexplanation.com, n.d.).

Shareholders, auditors, and other external groups base their judgment on income statements prepared using the absorption method. It influences managers to base their decisions on activities that can bring improvement on the absorption income statements. The variable cost method is preferred for internal reporting because it shows the contribution margin. It may be used for cost control of separate products, and segments (accountingexplanation.com, n.d.).

## Computations

The past data have been used to estimate future costs. Mingxinlu (2009) discusses that data obtained from past operations may be used to give accurate forecasts of costs. In the calculations below, the costs and sales quantities are similar to the past operations. In variable costing income statements, the fixed overhead (\$600,000) is subtracted from the cost of goods sold (\$1,800,000) to obtain the variable cost of goods sold (\$1,200,000). The production cost per unit in the absorption method is obtained by dividing the cost of goods sold by the number of units produced (accountingformanagement.com, n.d.). In the first quarter, \$1,800,000 has been divided by 25,000 units to obtain \$72 per unit as production cost.

The variable cost of goods sold is divided by the number of units to obtain the production cost per unit. In the first quarter, \$1,200,000 cost of goods sold is divided by 25,000 units to obtain \$48 per unit. The fixed costs have been deducted from \$1,800,000 before it is divided by 25,000 units (Martin, n.d.). In the second quarter, production cost per unit follows the same procedure for the absorption method (Martin, n.d.). The production cost per unit in the first quarter is used to calculate the variable cost of goods sold in the second quarter. The number of units (50,000) is multiplied by the production cost per unit (\$48) to give the variable cost of goods sold (\$3,000,000).

Jokkmokk first quarter.

 Jokkmok Industries Division Income Statement – Absorption method For the quarter ending March 31, 2013 production cost/ unit Sales (25,000) \$2,500,000 \$1,800,000/ 25,000 Cost of goods sold \$1,800,000 =\$72 Gross profit \$700,000 Selling & general expenses \$350,000 Net income \$350,000

Jokkmok first quarter.

 Jokkmok Industries Production cost per unit Division Income statement – variable cost method For the quarter ending March 31, 2013 sales (25,000 units) \$2,500,000 Less variable expenses: cost of goods sold \$1,800,000 Less fixed overheads \$600,000 \$1,200,000/25,000 variable costs of goods sold \$1,200,000 =\$48 contribution margin (\$2,500,000 – \$1,200,000) \$1,300,000 Less fixed expenses: fixed manufacturing overheads \$600,000 selling and general expenses \$350,000 Net income (\$1,300,000 – \$950,000) \$350,000 Jokkmok Industries Division Income Statement – Absorption method For the quarter ending June 30, 2013 production cost/ unit Sales (25,000 units) \$2,500,000 Less cost of goods sold: Beginning inventory \$0 Add cost of goods manufactured (50,000 units X\$60 ) \$3,000,000 Goods available for sale \$3,000,000 Less ending inventory (25,000 units X \$60) \$1,500,000 \$3,000,000/ 25,000 Cost of goods sold \$1,500,000 =\$60 Gross profit \$1,000,000 Less selling and general expenses \$350,000 Net income \$650,000
 Jokkmok Industries Division Income statement – variable cost method For the quarter ending June 30, 2013 production cost/ unit Sales (25,000 units) \$2,500,000 Less variable expenses: Beginning inventory \$0 Add variable manufacturing costs (50,000unitsX\$48) \$2,400,000 Goods available for sale \$2,400,000 Less ending inventory (25,000unitsX\$48) \$1,200,000 \$1,200,000/ 25,000 units Variable cost of goods sold \$1,200,000 =\$48 Contribution margin (\$2,500,000 – \$1,200,000) \$1,300,000 Less fixed expenses: fixed overheads \$600,000 selling and general expenses \$350,000 \$950,000 Net income \$350,000

## Discussion

### Mr. Rosen’s improvement in performance

Mr. Rosen’s performance has not improved based on the contribution margin method. The second quarter shows a contribution margin of \$1,300,000 similar to the one in the first quarter. The absorption method indicates that the gross profit and net income have increased for the division. Gross profit increased from \$700,000 to \$1,000,000 in the second quarter under the absorption method. In the variable cost method, the net profit has remained the same at \$350,000. Mr. Rosen’s performance has not improved based on the contribution margin. Walther (2012) explains that managers’ performance should be based on the contribution margin.

Mr. Rosen’s performance could have improved in the third quarter if he were to use the inventory, and shut down completely for the entire period. Walther (2012) discusses that shutting down completely is unlikely. Most of the times labor unions require that workers are paid despite the fact that workers and machines are not engaged in any production. There are firing and hiring costs attributed to a complete closure. Mr. Rosen would have saved on fixed overhead costs if he were allowed to shut down completely for three months. Selling and general expenses would still be incurred in the next quarter despite a complete closure. Large inventory is associated with increased holding costs.

### Suggestions for reporting in the future

The absorption method may fail to show improvement in efficiency. Absorption method indicates that Mr. Rosen performance, based on production cost, has improved from \$72 per unit to \$60. The variable cost method shows that production cost per unit have remained the same in the second quarter as they were in the first quarter of \$48 per unit. It shows there is a lack of improvement in production efficiency. The variable cost method is a good method for internal reporting because it shows key areas of improvement.

In this case, the contribution margin has not increased which indicates there is no improvement in the manager’s performance. Managers can easily use an absorption method to show an increase in net income by increasing inventories (accountingformanagement.com, n.d.). Internally, companies should use the variable cost method and production costs per unit to measure a manager’s performance. The variable cost method can be used for controlling cost because it shows the actual improvement (accountingexplanation.com, n.d.).

### Mr. Rosen for CEO

Mr. Rosen should not be considered for the CEOs position because he seeks to increase profitability of the firm by increasing inventories. The absorption method may indicate increased performance in the current period when the actual profitability has remained unchanged. Mr. Rosen should be considered for the CEO when his contribution margin has increased, and cost per unit has reduced. Reducing production costs has a long-term advantage. The division can use competitive pricing if it is able to lower its production costs. Companies use lower prices to gain a larger market share.

## Three shortcomings of the absorption method

The level of profits in the absorption method is affected by the level of inventories (accountingexplanation.com, n.d.). As it can be seen in the calculations above, an increase in inventory indicates that the firm’s profitability has improved. The same data using a variable cost method shows that there is no improvement in profitability. Managers who want to show an improvement in profits may simply increase the level of inventory before the end of the financial period.

The absorption method may not be used directly with cost control methods. The fixed costs and variable costs are mixed up. The controllable costs are not distinctly displayed (accountingexplanation.com, n.d.). Cost control requires that the variable cost be separated from the fixed cost. Fixed cost cannot be controlled in the current period. The variable cost can clearly show the level of improvement when changes are made than when they are combined with fixed costs.

The absorption method does not show the contribution of segments to the overall profitability of the firm. Most of the costs are generalized. The variable cost method can be used to show the “profitability of products, customers, and other segments of the business” (accountingexplanation.com, n.d., para. 5). The data required for a cost-volume-profit analysis cannot be obtained directly from a statement prepared using the absorption method (accountingexplanation.com, n.d.). It requires separation of variables and fixed costs.

## Conclusion

Absorption method is the commonly used accounting procedure for income statements because of the GAAP requirements. Managers may be determined to influence activities that may cause improvement in the income statement prepared using absorption accounting when there are no actual changes under contribution margin accounting. It is necessary for organizations to prepare income statements for internal cost controls using the variable cost method. Contribution margins are also essential in evaluating a manager’s performance.

## References

accountingformanangement. (n.d.). Income comparison of variable and absorption costing. Web.

Mingxin Liu, X. (2009). Determining How Costs Behave. Web.

Walther, l. (2012). Principles of Accounting. Chapter Twenty-Three: Variable versus Absorption Costing. Web.

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