The crucial distinction between fixed and variable costs is at the heart of the contribution approach to constructing income statements. The unique thing about the contribution approach is that it provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore aids planning, controlling, and decision making. The right-hand side of shows a contribution format income statement for merchandising companies.
The contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain the contribution margin. For a merchandising company, cost of goods sold is a variable cost that gets included in the “Variable expenses” portion of the contribution format income statement. The contribution margin is the amount remaining from sales revenues after variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the period.
The contribution format income statement is used as an internal planning and decision-making tool. Its emphasis on cost behavior aids cost-volume-profit analysis (such as we shall be doing in a subsequent chapter), management performance appraisals, and budgeting. Moreover, the contribution approach helps managers organize data pertinent to numerous decisions such as product-line analysis, pricing, use of scarce resources, and make or buy analysis. All of these topics are covered in later chapters.
Cost Classifications for Assigning Costs to Cost Objects
LEARNING OBJECTIVE 6
Understand the differences between direct and indirect costs.
Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies, and controlling spending. A cost object is anything for which cost data are desired—including products, customers, jobs, and organizational subunits. For purposes of assigning costs to cost objects, costs are classified as either direct or indirect.