Answer:
1. Preparing Contribution Income statement
Sales = 40,000 units X $42.60 = $1,704,000
Less: Variable Costs
Direct Material = $11 X 40,000 = $440,000
Direct Labor = $3 X 40,000 = $120,000
Variable Manufacturing Overhead = $3 X 40,000 = $120,000
Variable Selling Expenses = $4 X 40,000 = $160,000
Total Variable Costs = ($840,000)
Contribution Margin = $864,000
Less: Fixed Costs
Selling & Administrative = $300,000
Manufacturing Overheads = $196,000
Total Fixed Cost = ($496,000)
Net Operating Income = $368,000
2. Now we have net income as per Contribution statement = $368,000 and net income as per Absorption Costing = $404,000
This difference is because of Fixed Manufacturing Overheads
Under Absorption costing Fixed Manufacturing Overheads charged = $196,000 ÷ 49,000 units = $4 per unit X 40,000 units = $160,000 whereas in contribution statement it is charged fully.
Under absorption costing even fixed costs are charged based on the number of units produced, whereas in income statement is it charged completely irrespective of the units produced as that value is fixed and cannot be avoided on per unit basis.
Difference = $404,000 - $368,000 = $36,000
Manufacturing cost for 9,000 units (49,000 - 40,000) = at the rate of $4 = $36,000
In case cost of fixed manufacturing overhead is reduced by $36,000 then profit will be increased to $368,000 + $36,000 = $404,000 same as of absorption costing.
