The contribution margin income statement is a very useful tool in planning and decision making. While it cannot be used for GAAP financial statements, it is often used by managers internally.

The contribution margin income statement is a cost behavior statement. Rather than separating product costs from period costs, like the traditional income statement, this statement separates variable costs from fixed costs.

The basic format of the statement is as follows:

Variable costs, no matter if they are product or period costs appear at the top of the statement. Fixed costs are treated the same way at the bottom of the statement. It is helpful to calculate the variable product cost before starting, especially if you will need to calculate ending inventory.

Let’s run through an example to see how the income statement is constructed. We will use the same figures from the absorption and variable product cost post.

The first thing to remember about any income statement is that the statement is calculated based on the amount of product sold, not the amount of product produced. Therefore, this income statement will be based off the sale of 8,000 units.

To calculate sales, take the price of the product and multiply by the number of units sold.

Sales = Price X Number of units sold

Sales = \$100 X 8,000

Sales = \$800,000

Next, we need to calculate the variable costs. In the absorption and variable costing post, we calculated the variable product cost per unit.

This covers the product costs, but remember we must include all the variable costs. There is also \$5 of variable selling cost that should be included. Multiply the total variable cost per unit by the number of units sold.

Total variable cost = Variable cost per unit X Number of units sold

Total variable cost = (\$44 + \$5) X 8,000

Total Variable Cost = \$392,000

Contribution margin is the amount of sales left over to contribute to fixed cost and profit. Contribution margin can be expressed in a number of different ways, including per unit and as a percentage of sales (called the contribution margin ratio). In the contribution margin income statement, we calculate total contribution margin by subtracting variable costs from sales.

Total contribution margin = Sales – Variable costs

Fixed costs include all fixed costs, whether they are product costs (overhead) or period costs (selling and administrative). One thing that causes the contribution margin income statement and variable costing to differ from the traditional income statement and absorption costing is the fact that fixed overhead is treated as if it were a period cost. All fixed overhead is expensed in the period it is incurred. Under absorption costing, fixed overhead is attached to each unit. Therefore if there are units that are not sold, a portion of the fixed overhead ends up in inventory. That is not the case when using variable costing.

Total fixed overhead = \$48,000 + \$112,000

Last step: subtract fixed costs from contribution margin to calculate operating income.

#### Final Thoughts

The contribution margin income statement is all about behavior. Remember the format and ignore the traditional (absorption) income statement. Most students that have trouble with this statement try to relate it back to what is happening on the traditional income statement. Throw out what you know about the traditional income statement when doing the contribution margin income statement. Focus on the format of this statement and you should be fine.

#### Related Video

The contribution margin income statement

It could be argued that the statement of cash flow is the most important of all the financial statements. It is also the least understood. Understanding the purpose of the statement of cash flow is the key. Once you understand the purpose of the statement, wrapping your brain around how to complete it is much easier.

Most people have a difficult time understanding the concept of accrual accounting. I believe this is because most people live in a cash basis world. As individuals, we do not consider income when it is earned. We recognize our income when it is paid. We recognize expenses when they are paid. It is important to remember that most businesses do not operate that way. Most businesses recognize income when the work is done, whether or not the job has been paid for. These businesses recognize expenses when the cost is incurred, regardless of payment status. In business, we are frequently recording income and expenses when no money has changed hands.

This causes a problem for many people looking at the financial statements. Individuals think in terms of cash so when an individual sees a company with a profit of \$500,000, he or she may think that there is an additional \$500,000 worth of cash sitting in the bank at the end of the year. Cash might have only increased slightly. It could have even decreased! When that money is not there, the person may believe there is a problem with the income statement.

The purpose of the statement of cash flow is to explain the difference net income and the change in cash over the same period. If there was a \$500,000 profit, the statement of cash flow explains why the increase in cash is not also \$500,000. The statement begins with net income. Each line on the statement explains where cash is coming from, called a source of cash, or where cash is going, called a use of cash. The statement ends with the amount that cash has increased or decreased over the course of the period and the ending balance in cash.

Every source or use of cash can fit into one of three categories: operating activities, investing activities or financing activities.

Operating Activities

These are activities related to operations or the income statement. In other words, these are items related to income and expenses. There are two main types of operating activities: noncash and those related to current assets and current liabilities.

Noncash operating activities relate to items that appear on the income statement, yet cash was not affected by that item. The most common noncash item is depreciation. Think about the entry recorded for depreciation.

The entry creates an expense, which appears on the income statement but no cash changes hands. On the income statement, the expense lowers net income but there is no corresponding decrease in cash. This leads to one of the differences between net income and change in cash.

Since the depreciation was subtracted on the income statement, we need to add it back to net income on the statement of cash flow. Adding it back removes it from net income, helping us get closer to the change in cash.

Other noncash items include amortization, gains and losses. While some cash may change hands when an asset is sold, the amount of cash received relates to the removal of the asset. The gain or loss on the transaction is considered to be a noncash part of the transaction. It is essentially there to balance the transaction.

Notice that \$5,000 in cash was received, not \$2,000. We eliminate the \$2,000 gain in the operating section. Later, we will see what happens to the \$5,000.

Any noncash item that is added on the income statement, a gain for example, is subtracted on the statement of cash flows to remove it. Noncash items that are subtracted on the income statement are added back on the statement of cash flows.

Changes in current assets and current liabilities are the second type of operating item. Think of some common current assets and current liabilities: accounts receivable and accounts payable. Both of these items are linked to the income statement.

Current Assets and Changes in Cash

Accounts receivable is created when a company does work and creates revenue. The work has not yet been paid for. However, the income appears on the income statement. This could create a difference between net income and the change in cash. When trying to determine if there is an effect on the change in cash, we need to look at how much accounts receivable has changed. Let’s look at three different scenarios.

Example #1

2012 ending balance in Accounts Receivable was \$230,000
2013 ending balance in Accounts Receivable was \$230,000
Sales were \$3,000,000

If Accounts Receivable was \$230,000 at the end of 2012 and is still \$230,000 at the end of 2013, that means that \$3,000,000 worth of sales were collected in 2013.

The amount of sales and the amount of cash collected are equal. Therefore, no timing difference exists. There difference between net income and cash is not affected by accounts receivable.

Example #2

2012 ending balance in Accounts Receivable was \$330,000
2013 ending balance in Accounts Receivable was \$230,000
Sales were \$3,000,000

In this example, Accounts Receivable decreased by \$100,000. Let’s see how this decrease affects the amount of cash collected.

The company reported \$3,000,000 in sales on the income statement but actually collected \$3,100,000 in cash related to sales. The decrease in accounts receivable results in an increase in cash. That makes sense because when accounts receivable balances are paid (and the balance decreases), the company receives cash.

The \$100,000 difference creates a positive change in cash. You could also say that the \$100,000 decrease in accounts receivable is a \$100,000 source of cash.

Example #3

2012 ending balance in Accounts Receivable was \$230,000
2013 ending balance in Accounts Receivable was \$330,000
Sales were \$3,000,000

Now we have a \$100,000 increase in accounts receivable. What effect do you think this has on cash? If accounts receivable is increasing, the company doesn’t have the cash. Let’s look at the calculation.

Only \$2,900,000 was collected over the course of the year but sales of \$3,000,000 appear on the income statement. The \$100,000 creates a negative change in cash. My change in cash in this case is less than net income because the company did not collect those funds.

You might be concerned at this point because this seems like a lot of work to do for every line of the cash flow statement. This is just to illustrate what happens. If accounts receivable increases, the change in cash decreases by the same amount. If accounts receivable decreases, the change in cash increases by the same amount.

When completing the statement of cash flow, calculate the change in the account balance. Ask yourself who has the money resulting from that change. Go back to example #2. Accounts receivable decreased by \$100,000. Who has the \$100,000? The company does because customers paid the additional \$100,000. This results in an increase in cash. In example #3, the customers had the \$100,000 because they had not paid their bills. This results in a decrease in cash for the company. This method works for all current assets and current liabilities.

All assets behave like accounts receivable. If the balance in prepaid expenses increases, more cash is trapped in that account, resulting in a decrease in cash. If the balance in inventory decreases, the company used up some of the previous inventory rather than spending cash to purchase more. Cash increases because of this.

Current Liabilities and Changes in Cash

Current liabilities, like accounts payable, react the opposite way that assets do. Again, we are examining the differences in current liabilities to determine how these changes affect the change in cash. Let’s run through a few examples just to get the hang of it.

Example #4

2012 ending balance in Accounts Payable was \$150,000
2013 ending balance in Accounts Payable was \$105,000
Expenses were \$2,500,000

Accounts payable decreased by \$45,000. Why did accounts payable decrease? Because the company paid all the current expenses and paid off some of last year’s balance. The company paid down debt. This has a negative impact on the change in cash. Let’s look at the full calculation to confirm.

The company paid \$45,000 more in cash than it recorded in expense. This causes a decrease in cash. It can also be said that the decrease in accounts payable is a use of cash.

Example #5

2012 ending balance in Accounts Payable was \$150,000
2013 ending balance in Accounts Payable was \$175,000
Expenses were \$2,500,000

Now, accounts payable is increasing. The company charged more to accounts payable over the course of the year than the company paid off. The \$25,000 difference is a source of cash. The company was able to write off expenses that it has not yet paid for.

The company’s income statement shows expenses of \$2,500,000 but the company only spent \$2,475,000. It kept the \$25,000. Because of the \$25,000 increase in accounts payable, the change in cash increased by \$25,000.

All current liabilities behave like accounts payable. When accounts payable decreases, cash decreases because cash was used to pay down the liability. When accounts payable increases, cash increases as well because the company used debt rather than cash to finance its activities.

Steps to Complete the Operating Section

1. First calculate the change in the account balance.
2. Ask yourself who has the cash from that change. If the company has the cash, it is an increase in cash.  If someone else has the cash, customers or vendors for example, it is a decrease in cash.
3. Don’t forget to look for noncash items as you work your way down the balance sheet: depreciation, amortization, gains and losses.

Investing Activities

In this section, we are concerned with investments that the company has made. What do companies invest in? Long-term assets that will help with company increase revenue. This includes buildings, machinery, intangible assets, investments in other companies and other long-term investments.

In the investing section, we are not allowed to explain a difference in an account balance by listing “change in fixed assets.” The investing section requires us to explain each change. Let’s look at an example.

Example #1

2012 ending balance in Vehicles was \$250,000
2013 ending balance in Vehicles was \$235,000
In 2013 the company sold a vehicle which was originally purchased for \$35,000 for \$5,000. The vehicle had \$33,000 of accumulated depreciation recorded at the time of sale.

When dealing with assets, we may not have all the transactions listed, but we will always have all the information we need to do the calculation. Let’s start with the beginning balance and run through the information we have so far.

This does not make sense because the account balance was \$235,000. Clearly, something else happened which was not listed in the information. What would cause the balance in the vehicles account to increase? The company must have purchased another vehicle. How much was the new vehicle? It must have been \$20,000.

Now that we have identified all the activity in the vehicles account and were able to reconcile the change in the balance. We now must figure out what we need to record. We must forget for a moment the vehicles and turn our attention to the cash that changed hands.

The company sold a vehicle. How much cash was received? \$5,000. It does not matter that the vehicle originally cost \$35,000. Now we are only concerned with cash. The company also purchased a vehicle. How much cash was paid? \$20,000. On the statement of cash flow, we would record these two items.

Notice, we listed each item separately. We need to explain to the reader what happened.

You might have noticed that there was a gain on the sale of the vehicle. The vehicle had a book value of \$2,000 (\$35,000 cost – \$33,000 accumulated depreciation). If \$5,000 was received, there was a \$3,000 gain. Remember when we discussed noncash items in the operating section. This gain would be listed in the operating section and subtracted from net income.

You should follow this procedure for all noncurrent assets on the balance sheet.

1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
2. If the balance matches your reconciliation, you are finished. Record the items listed.
3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. This activity must be an asset purchase. Calculate how much the asset purchase was.
4. In the statement of cash flow, list all transactions separately, as shown above.

Financing Activities

In our analysis of the balance sheet, we have covered current assets, current liabilities and long-term assets. The only items remaining are long-term liabilities and equity. Both of these items go into the financing section.

The financing section is similar to the investing section. We must explain what happened, not just list the changes in each account balance.

Example #1

2012 ending balance in Notes Payable was \$95,000
2013 ending balance in Notes Payable \$75,000
The company borrowed \$35,000 in additional loans

Looking at this example, it is clear that there is information missing. The company borrowed additional money but the Notes Payable balance decreased. That just doesn’t make sense with the information we are given. There are two ways to work this calculation. we can reconcile the balance, similar to the method used in the investing section.

What is causing the balance to be \$55,000 less than anticipated? Think about the reason that the balance in Notes Payable would decrease. Debts decrease when they are repaid. The company must have repaid \$55,000 on the debt.

Here is how we would list this on the statement of cash flow in the financing section:

You should follow this procedure for all noncurrent liabilities on the balance sheet.

1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
2. If the balance matches your reconciliation, you are finished. Record the items listed.
3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. Calculate the amount you are off and the reason for the change.
4. In the statement of cash flow, list all transactions separately, as shown above.

Completing the Statement of Cash Flows

Whenever I am working on a cash flow statement, I use the balance sheet as a guide.

First, calculate how much each account has changed from the previous year.

Starting at the top of the balance sheet, I work my way through each account. The first account should be cash. We can skip that one since the purpose of the statement of cash flow is to match the change in cash. The next account is most likely accounts receivable. Determine which section accounts receivable would go into: operating, investing or financing (if you said operating, you are correct). Then ask yourself if the change in the balance is a source of cash or a use of cash. Add it to your statement.

Use this same procedure, explaining all the differences and adding them to the correct section of the cash flow statement. When you have explained all the differences, total each section and then add all three sections together to calculate your change in cash. The change in cash you calculate should equal the difference between your beginning and ending cash balance.

#### Related Videos

Cash Flow Statement Basics

Completing the Cash Flow Statement