Question

Explain the CM approach and its advantages. Would the CM approach better assist management in ensuring that all costs will be covered? I think that under absorption costing, FC would become inventoriable and thus buried when production exceeds sales. Conversely, under the CM approach, FC are treated as period costs, and thus it is less likely to overstate profits. What are your thoughts on this topic?

Answer 1

Contribution margin means sales value less all variable costs,be them manufacturing, selling & administration.

Under contribution margin approach,the management is able to know the contribution made by each unit of additional sales , towards meeting the fixed costs of the organisation.

It helps the management to study the relationship between cost, volume of sales and final profit.

A sale that is not even meeting the variable costs to produce that product, is certain to contribute nothing towards any of the company's fixed costs ,like office salaries or costs such as rent & insurance.

So, the management is quick & clear in taking decisions such as make or buy,continue or discontinue--by employing the already available cost & sale details to find contribution .

It is most useful for internal management- decision making.

Yes. In a way,it certainly,helps the management to know its variable & fixed costs, in toto--only on that basis , variable costs are subtracted from sales revenue to know the quantum of contribution towards meeting the fixed costs.

The excess of total contribution over the fixed costs are the pre-tax operating income.

YES.

When production exceeds sales, meaning closing inventory is greater than the opening inventory, the operating income under absorption costing is greater ,as the fixed costs are deferred in the closing inventory & out of the operating costs for that period--that naturally increases the operating income for this period.

Under the CM approach, which is based on variable product costs, fixed manufacturing overhead cost is not treated as product cost --but fully charged to the current year income --nothing is absorbed by the ending inventory.

Hence current year profits are more under absorption/full costing than under CM /Variable costing approach.

as closing inventory is greater under the former & greater amounts are deferred-the main difference being the fixed manufacturing Ohs