ACC 333 (De Meyst)

Two Types of Income Statements

Income statements can be based on either:

 Absorption costing (which is used for external reporting)
 Variable costing (which is used for internal decision-making)
Both are based on the fundamental income statement accounting equation:
Revenues – Expenses = Income
The difference is in the classification and reporting used for the expense (i.e., costs) part of the equation

On an absorption costing income statement:

 Cost of goods sold (COGS) = Direct material (DM) + Direct labor (DL) + Manufacturing
Overhead (OH)
 Gross profit (a.k.a. gross margin) = Sales – COGS
o This is a key subtotal that signals this income statement is prepared using absorption
costing
 Costs are classified by functional area in the firm
o Functions that produce product/service vs. All other functions (selling, general, and
administrative expenses, or SG&A)
 All costs to produce products/services are in COGS
 Why use this methodology?
o It is required by GAAP
o Gross profit enables external users to evaluate the costs (i.e., the size of their investment)
needed to generate a certain level of sales, including investments in fixed assets
ACC 333 (De Meyst)

Why use variable costing?

 Since firms must use absorption costing for external reporting, that’s how accounting systems are
set up
 But for internal decision-making, costs allocated using absorption costing may not be useful
o Managers are usually more interested in how costs change across their alternatives, rather
than what functional area in the firm incurs the costs
 And fixed costs frequently don't change across alternatives
o But absorption costing:
 buries fixed costs in product/service costs (as if they change with volume)
 treats fixed costs as if they were variable (“unitized fixed costs” from using a
predetermined overhead rate)
 does not include variable SG&A as a cost of the product

On a variable costing income statement:

 Contribution margin (CM) = Sales - variable costs
o This is a key subtotal that signals that an income statement is prepared using variable
costing
 Costs are classified by behavior
o Variable vs. Fixed
 Why?
o Variable costs are usually relevant in evaluating different alternatives
o Easier to understand the impact of changes in sales on profit
o Stresses the need to recoup (i.e., recover) fixed costs before profit can be earned (as
in breakeven analysis)

With: * Variable manufacturing = DM + DL + variable OH

** Fixed manufacturing = fixed OH
ACC 333 (De Meyst)
ACC 333 (De Meyst)

NOTE: When you are given one type of income statement, you can easily compute the other!

When given gross margin, you can compute CM:

gross margin (which is sales – COGS)

+ fixed costs to produce products/services
- variable non-production costs
contribution margin (which is sales – VC)

When given CM, you can compute gross margin:

contribution margin (which is sales – VC)

- fixed costs to produce products/services
+ variable non-production costs
gross margin (which is sales – COGS