Chapter 19: Decision Analysis: Contribution Margin

This passage focuses on using the contribution margin ratio to analyze and make business decisions, specifically for sales territories and product lines. It also contrasts variable costing and absorption costing for income reporting. Key Concepts: 1. Contribution Margin and Contribution Margin Ratio: o Contribution Margin = Sales − Variable Expenses. o Contribution Margin Ratio = Contribution Margin / Sales. o A higher contribution margin ratio indicates that a larger percentage of sales is available to cover fixed costs and contribute to net income. 2. Using Contribution Margin for Decision-Making: o Example Calculation: If sales are $500,000 and the contribution margin is $200,000, the contribution margin ratio is 40% ($200,000 / $500,000). This means that for every dollar of sales, 40% contributes to covering fixed costs and generating income. 3. Application by Sales Territory (IceAge Example): o IceAge has two sales territories: Western and Eastern. Both territories have the same sales volume and selling prices per unit. However, variable selling and administrative expenses differ. o Eastern Territory has a higher contribution margin ratio (59%) compared to the Western Territory (56%), primarily due to lower variable selling and administrative expenses in the Eastern territory. o Managerial Decisions:  Consider reducing variable expenses in the Western territory.  Increase sales efforts in the Eastern territory, given the higher contribution margin ratio. 4. Application by Product Line (IceAge Example): o IceAge has two product lines: Hockey Skates and Figure Skates. Both have the same selling prices and variable expenses per unit, but the figure skates have a higher variable cost of goods sold. o The contribution margin ratio for hockey skates (60%) is higher than that for figure skates (55%). o Managerial Decisions:  Increase the selling price for figure skates to improve profitability.  Focus on decreasing the variable cost of goods sold per unit for figure skates.  Increase sales efforts for hockey skates due to their higher contribution margin ratio. Variable vs. Absorption Costing: • • Absorption Costing includes all manufacturing costs (fixed and variable) in the product cost, while Variable Costing only includes variable manufacturing costs. The passage references Navarro Company to demonstrate income statements under both costing methods for two years. This exercise shows how product cost per unit and income reporting differ under each approach. Income Statements under Variable and Absorption Costing: 1. Absorption Costing Income Statement: o Includes direct materials, direct labor, variable and fixed manufacturing overhead as part of product costs. o Gross profit is calculated as Sales – Cost of Goods Sold. o Fixed manufacturing costs are included in the Cost of Goods Sold. 2. Variable Costing Income Statement: o Only variable costs (direct materials, direct labor, and variable overhead) are included in the product costs. o Contribution margin is calculated as Sales – Variable Costs (both variable COGS and variable selling/administrative expenses). o Fixed manufacturing overhead is treated as a period cost and deducted separately from the contribution margin. Understanding these concepts enables managers to use contribution margin analysis and cost reporting techniques to make more informed business decisions, adjust pricing strategies, allocate resources efficiently, and improve overall profitability.