A traditional income statement contains several blocks of revenue and expense information, which are organized as follows:
- Revenue block. Usually a one-line aggregation of gross sales and a variety of sales deductions and allowances.
- Cost of goods sold block. Includes the cost of direct materials, direct labor, and allocated factory overhead. Contains a mix of fixed and variable expenses.
- Gross margin line. The net amount of all revenues, minus the total amount of the cost of goods sold.
- Selling and administrative block. Includes all expenses associated with the selling, general, and administrative functions of a business.
- Operating profit/loss line. The gross margin line, minus the total amount of selling and administrative expenses.
- Non-operating expenses block. Includes all non-operating expenses, such as financing expenses and gains or losses on the disposal of assets.
- Net income line. The operating profit/loss line, minus the total amount of the non-operating expenses block.
The traditional income statement approach is the dominant format used by nearly all companies, because it is required by the accounting standards for the reporting of financial results to outside parties. Because the traditional income statement involves the use of cost allocations within the cost of goods sold block of information, it can be difficult to determine which costs vary with changes in sales.
An alternative format is the contribution margin income statement, in which variable expenses are aggregated into what would have been the cost of goods sold block in a traditional income statement. All other costs, which should be fixed costs, are aggregated into a block that is positioned below the contribution margin line. The result in the net income line is the same, no matter which format is used.
The contribution margin approach can be of use for internal reporting, when a company wants better visibility into the results of its operations and how its net income will vary in response to different changes in revenue levels.