When preparing a contribution margin income statement, it is necessary to breakdown costs into what two categories?
Answer
a. Variable and fixed
b. Product and period
c. Avoidable and unavoidable
d. Direct materials and indirect materials
The Correct Answer and Explanation is:
Correct Answer: a. Variable and fixed
Explanation:
When preparing a contribution margin income statement, it is essential to break down costs into variable and fixed categories. This classification is foundational to cost-volume-profit (CVP) analysis, which helps management understand how changes in sales volume affect profits.
In a traditional income statement (used for external reporting), expenses are classified based on function—such as cost of goods sold, selling, and administrative expenses. However, in a contribution margin income statement, costs are organized based on behavior: whether they change with the level of activity (variable) or remain constant (fixed) within a relevant range.
- Variable Costs: These costs change in direct proportion to changes in sales or production volume. Examples include direct materials, direct labor (in some settings), sales commissions, and shipping costs. They are deducted from sales to arrive at the contribution margin.
- Fixed Costs: These costs remain unchanged regardless of the level of production or sales volume (within the relevant range). Examples include rent, salaries, insurance, and depreciation. After calculating the contribution margin, fixed costs are subtracted to determine operating income.
Contribution Margin Income Statement Format:
Sales
- Variable Expenses
= Contribution Margin
- Fixed Expenses
= Net Operating Income
This format allows managers to easily analyze how sales affect profitability, make informed decisions about pricing, production levels, and cost control, and perform break-even and margin of safety analysis. Because it focuses on cost behavior, the contribution margin format is a powerful tool for internal decision-making but is not typically used for external reporting under GAAP or IFRS.
In conclusion, categorizing costs into variable and fixed is critical in a contribution margin income statement because it aligns with managerial accounting’s goal of aiding internal decision-making.
