Contribution vs. Absorption Approach

Contribution Approach (Not GAAP)

• Revenue - Variable cost = Contribution Margin - Fixed costs = Net income
• Variable costs (DM + DL + Variable O/H + Variable SG&A)
• Fixed costs (Fixed O/H + Fixed SG&A)

Unit contribution margin = Unit sales price - Unit variable cost

Contribution margin ratio = Contribution Margin / Revenue

Absorption Approach (Product vs. Period)

• Revenue - COGS = Gross Margin - Operating expenses = Net income
• COGS (DM + DL + O/H [Variable & Fixed])
• Operating expenses (SG&A period cost)

Difference between Contribution Approach & Absorption Approach 

• Absorption costing: Product costs include Fixed Manufacturing Overhead
• Only expense for portion of units sold 
• Variable costing: Period costs include Fixed Manufacturing Overhead

Effect on Income

• No change in inventory: Absorption net income = Variable net income
• Increase in inventory: Absorption net income > Variable net income
• Fixed O/H to be expensed decreases
• Decrease in inventory: Absorption net income < Variable net income
• Fixed O/H to be expensed increases