- Explain the Traditional Format Income Statement
- Explain the  Contribution Format Income Statement
- Explain and show examples of Cost Classifications for Decision Making


[SLIDE 1]

Managerial accountants have different formats for income statements. One is the traditional format, which primarily is used for external reporting, and the other is the contribution format, which is used for internal reporting to managers of the organization.

The reason for the two formats is that external users are not as concerned with the breakdown of costs in the organization but more with whether the company is making a profit. Internal management requires this breakdown of cost in order to plan, control and make decisions for the organization so that it will continue to be profitable in the future.

To better understand the reasoning for two different formats let us look at each format in greater detail.  


[SLIDE 2]

The Traditional format income statement is primarily used for external financial reporting and simply breaks down costs by functional area are you can see in the example.  It does not show fixed or variable costs separately but as a total for cost of goods sold and selling and administrative costs.  This format does not assist management in determining areas of concern or planning for the organization.

This format must also comply with GAAP since it is used to report information to external users on the company's performance for a specified period.  


[SLIDE 3]

The Contribution format income statement, also called a contribution margin income statement, shows both the fixed and variable components of cost information.  This statement organizes the data in a way that makes it easier for management to assess how changes in production and sales will affect operating profit.  

In looking at the sample format, you can see how:
<strong>revenue minus variable costs equals the contribution margin (Income)</strong>

Then, the <strong>contribution margin (Income) minus fixed costs equals operating profit</strong>.

This statement provides a clearer picture of which costs change and which costs remain the same with changes in levels of activity.  So for example, if sales increases then you would expect variable cost to increase in proportion to the sales, however, if variable costs increase by more than what was expected, then the amount of variable cost increase would lower the contribution margin to cover fixed costs, which remains the same.   

The main difference in the two formats is the way that fixed and variable costs are reported on the income statement. We will be using the contribution format in future lessons as we discuss concepts of managerial accounting.


[SLIDE 4]

Costs play an important role in many business decisions. Therefore, it is essential for management to have a firm grasp on what differential cost, opportunity cost and sunk costs are.

<strong>Differential cost</strong>, also known as incremental cost, is the difference in costs between two alternatives.  Differential costs can either be fixed or variable.  For example, if a company is looking at producing a product rather than purchasing it, the difference in the cost to produce and buy helps management determine if it is cost effective to choose one option over the other.  

<strong>Opportunity cost</strong> is the potential benefit that is given up when one alternative is chosen over another. Using the example, a company is looking at investing money in land for a future plant expansion.  Rather than invest the funds in the land and hold for a future date, the company could invest the funds in high grade securities.  If they opt to purchase the land, the opportunity cost is the investment income that could have been realized by purchasing the securities instead.

<strong>Sunk cost</strong> is a cost that has already been incurred by a company that cannot be changed by any decision made now or in the future.  For example, a company purchased a machine several years ago to make specific parts that are now obsolete.  While in hindsight, this might not have been a good decision, the cost of the machine has already been spent and is now considered a sunk cost and should be ignored in current decisions.

All of these costs are discussed in greater detail in a future lesson.