Question

Discuss the reasons behind producing Income statement in both contribution and traditional formats

Answer 1

The preparation of income statement under traditional format is done as per absorption costing method where gross profit is calculated by subtracting cost of goods sold (COGS) from sales. Thereafter, marketing and general administrative expenses are deducted from such gross profit to arrive at the figure of net income. In this approach, bifurcation of fixed and variable costs is not carried out, therefore, the fixed costs also form part of the inventory. This format fulfils the requirements of both internal management and external parties, therefore, income statement of an entity is prepared in this format in order to comply with the Generally Accepted Accounting Principles (GAAP) or International Accounting Standards (IAS).

On the other hand, contribution format is based on the concept of marginal costing, where variable costs are deducted from sales to calculate the value of contribution. After that, all the fixed costs are reduced from such contribution to determine an entity's net income. It is prepared by an entity's internal management solely for the purpose of decision-making process. For instance- measuring the profitability of three products A,B and C to decide which products are to be continued and which ones are to be dropped. Income statements prepared under this format are not required to be presented to any external party, hence there is no requirement of following GAAP or IAS.