Chapter 2, Problem 19P

To determine

Variable Cost: The variable cost is a cost that changes when the volume of production changes, in the same direction and in the same proportion.

Fixed Cost: Fixed cost is a cost that remains constant irrespective of the changes in the production volume.

Income Statement: Income statement is a financial statement that shows the net income or loss for a particular period. It is the summary of expenses and income of a particular period.

Traditional Income Statement: In the traditional income statement, costs are organized or reported by functions such as production, administration, selling and marketing. Fixed and variable costs are merged within the respective function cost.

Contribution approach Income Statement: Income statement under contribution approach is prepared based on the variable and fixed costs. First, the variable expenses are deducted to obtain the contribution margin, and then the fixed expenses are deducted to obtain the net operating income.

1. An income statement using the traditional format.
2. An income statement using the contribution format.
3. Comments on why it is misleading to show the fixed costs on a per unit basis in the income statement prepared in (2) above.

Answer to Problem 19P

Solution:

1. Income Statement using the traditional format for the data given is prepared.
2. Income Statement using the contribution format for the data given is prepared.
3. Comments given on why it is misleading to show the fixed costs on a per unit basis in the income statement under the contribution format.

Explanation of Solution

1. Income Statement using the traditional format.

   Marwick's Pianos, Inc
   Traditional Income Statement
   For the month ended August 31
   No of pianos sold		40
   Sales		$125,000
   Less : Cost of goods sold		$98,000
   Gross Profit		$27,000
   Less: Selling expenses
   Advertising	$700
   Salaries and commissions	$10,950
   Delivery of Pianos to customers	$1,200
   Utilities	$350
   Depreciation of sales facilities	$800	$14,000
   Less: Administrative expenses
   Executive salaries	$2,500
   Insurance	$400
   Clerical	$1,800
   Depreciation of office equipment	$300	$5,000
   Net Income		$8,000

2. Income statement using the contribution format.

Marwick's Pianos, Inc
Contribution format Income Statement
For the month ended August 31
	Total	Per Piano
Sales (A)	$125,000	$3,125
Variable expenses
Cost of goods sold	$98,000	$2,450
Salaries and commissions	$10,000	$250
Delivery of Pianos to customers	$1,200	$30
Clerical	$800	$20
Total variable expenses (B)	$110,000	$2,525
Contribution margin (A-B) (C)	$15,000
Fixed expenses
Advertising	$700
Salaries and commissions	$950
Utilities	$350
Depreciation of sales facilities	$800
Executive salaries	$2,500
Insurance	$400
Clerical	$1,000
Depreciation of office equipment	$300
Total fixed expenses (D)	$7,000
Net Operating Income (C-D)	$8,000

3. Fixed costs remain constant irrespective of the change in the unit of pianos sold. As the sales level increases, for example, the fixed costs will decrease on a per unit basis or vice versa. Showing fixed costs on a per unit basis on the income statement might be misleading as it may seem that the fixed costs behave in the same way as the variable costs. That is, anyone using the data might be misled into thinking that per unit fixed cost would be the same regardless of how many pianos were sold during the month. For this reason, fixed costs are generally are shown only in totals on a contribution format income statement.

Calculation: Calculations and working are explained using the traditional income statement.

Marwick's Pianos, Inc		Calculations
Sales	$125,000
Cost of goods sold	$98,000
Salaries and commissions	$10,950
Delivery of Pianos to customers	$1,200
Clerical	$1,800

Conclusion

Thus, for the for Marwick’s Pianos, Inc. the income statement under both traditional and contribution formats are prepared and the calculations are explained.