Question

Gary G's is a small company that currently operates in Knoxville, TN and has a single product - stadium seat cushions bearing the University of Tennessee logo. Eventually Gary wants to expand and sell this product for other university and professional sports teams, and to add other merchandise. In the meantime, Gary is having a little difficulty understanding margins, and operating income and product mix. "I'll never understand this accounting stuff, Gary yelled, waving the income statement he had just received from his accountant in the morning mail. "last month we sold 1,000 stadium seat cushions and earned $6,850 in operating income. This month, when we sold 1,500, I thought we'd make $10,275. But this income statement shows an operating income of $12,100! How can I ever make plans if I can't predict my income? I'm going to give Cathy one last chance to explain this to me," he declared as he picked up the phone to call Cathy, his accountant. “Will you try to explain this operating income thing to me one more time please?" Gary asked Cathy. “After I saw last month's income statement, I though each cushion we sold generated $6.85 in net income; now this month, each one generates $8.07! There was no change in the price we paid for each cushion, and we didn't change our selling price, so I don't understand how this happened. If I had known I was going to have $12,100 in operating income, I would have looked more seriously at adding to our product line." Taking a deep breath, Cathy replied, “Sure, Gary. I'd be happy to explain how you made so much more operating income than you were expecting." Required: 1. Assume the role of Cathy. Explain to Gary why his use of operating income per cushion was in error. 2. Using the following income statements, prepare a contribution margin income statement for October September October Sales $25.000 $37.500 Cost of Goods Sold 10.000 15.000 Gross Profit 15.000 22.500 Rent Expense 1.500 1.500 Wapes Expenses 1000 5,000 Shipping c ense 1.250 1.875 Utilities expense 750 750 Advertising expense 750 875 Insurance expense Operating income S6XS0 S12.100 Wages and advertising are mixed costs. The fixed portion of each of those costs is $500.

Answer 1

a. Gary reports that the 'net income per unit' for September was 6.85 $ (which he obtained by $ 6850 /1000 units) and for October it is $ 8.07 (ie 12500/1500 units). However Net income is arrived at after considering Fixed Costs which remains constant regardless of the output. Thus the error Gary did was not using "Contribution margin per Unit" for comparison of both the months. However this has been done in 'b' below.

b.

Contribution Margin Income Statement

	September		October
	Total Amt	Per Unit	Total Amt	Per Unit
Sales	25000	25000/1000 = 25	37500	37500/1500= 25
- Variable Costs
COGS	10000	10000/1000 = 10	15000	15000/1500 = 10
Shipping	1250	1250/1000 = 1.25	1875	1875/1500 = 1.25
Wages	3000	3000/1000 = 3	4500	4500/1500 = 3
Advertisement	250	250/1000 = 0.25	375	375/1500 = 0.25
Contribution Margin (A)	10500	10.5	15750	10.5
Rent	1500	CONSTANT	1500	CONSTANT
Wages	500		500
utilities	750		750
Advertisement	500		500
Insurance	400		400
Total Fixed Costs (B)	3650		3650
Net Income (A- B)	6850		12100

Thus, it is clear that Contribution per Unit is $ 10.5 in both the months. Fixed Costs are constant.

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