Question

The Cornerstone Corporation produces and sells a single product. The following data refers to the year just completed:

List of Account Titles
Beginning inventory		0
Units produced		9,000
Units sold		7,000
Selling price per unit	$	47
Selling and administrative expenses:
Variable Cost per unit	$	4
Fixed Cost per year	$	58,000
Manufacturing costs:
Direct materials cost per unit	$	10
Direct labor cost per unit	$	6
Variable manufacturing overhead cost per unit	$	5
Fixed manufacturing overhead per year	$	90,000

a. If the managers use the variable costing approach to prepare an income statement, what is the dollar amount for the contribution margin account that would be reported on this type of income statement? Show all detailed supporting calculations that were used to determine the final answer.

b. If the managers use the absorption (traditional financial) costing approach to prepare an income statement, what is the dollar amount for the gross margin account that would be reported on this type of income statement? Show all detailed supporting calculations that were used to determine the final answer.

c. Provide a concept definition for the terms contribution margin and gross margin, and then explain why managers might prefer to use the contribution margin analysis approach to enable more effective decision making, rather than focusing on a gross margin that is part of the absorption costing approach.

Answer 1

a. Variable Costing Approach
Particulars	Units	Per unit	Total
Sales (A)	7000	$47	$3,29,000
Variable Expenses (B)
Selling and Admin Expenses	7000	$4	$28,000
Manufacturing costs	7000	$21	$1,47,000
($10 + $6+ $5)			$1,75,000
Contribution Margin C = (A-B)			$1,54,000
Fixed Expenses (D )
Selling and Admin Expenses			$58,000
Manufacturing costs			$90,000
			$1,48,000
Net Operating Income (C-D)			$6,000
b. Absorption Costing Approach
Particulars	Units	Per unit	Total
Sales (A)	7000	$47	$3,29,000
Cost of Goods Sold (B)
Variable Manufacturing costs	7000	$21	$1,47,000
($10 + $6+ $5)
Fixed Manufacturing Overhead	7000	$10	$70,000
($90,000/9000)
			$2,17,000
Gross Margin C = (A-B)			$1,12,000
Selling and Admin Expenses (D)
Variable Cost	7000	$4	$28,000
Fixed Cost			$58,000
			$86,000
Net Operating Income (C-D)			$26,000

C.

Gross profit margin measures the revenue that remains after subtracting costs directly associated with manufacturing. It does not take into consideration sales or administration expenses.

Contribution margin is a measure of the profitability of various individual products after subtracting variable costs from revenue. It does not take into consideration fixed costs.

The contribution margin is used to evaluate the profitability of an item out of a product portfolio and thus leads to more accurate and effective decision making.