Problem:
The E-Company manufactures trendy, high-quality moderately priced watches that it sells on the Internet. As the company's senior financial analyst, you are asked to analyze the overall profitability for the current year. The CFO has heard that there are two different approaches for preparing income statement. You are asked to show the CFO both approaches and explain the advantages or disadvantages of each method. The following data are for the year ended December 31, 20XX:
Production capacity
400,000 units
Ending inventory
55,000 units
Sales
345,000 units
Selling price
$29.00 per unit
Variable manufacturing cost (direct material: $3.50 and direct labor: $1.40) per unit
$4.90 per unit
Variable operating/selling cost per unit
$1.20 per unit
Total fixed manufacturing overhead
$1,600,000
Total ixed selling & administrative expenses
$1,200,000
Assume costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume the prices and unit costs did not change during the year.
Requirement:
Prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 20XX.
What are E's contribution margin ratio, gross profit ratio and operating (net) income ratios?
Explain the difference and reconcile operating income for the two methods.
If E sells 10,000 additional units, how much better off is the company financially? Which income method did you use? Please explain and show your computations.
Which costing method would you recommend to the CFO? Why?