Problem 14-18 Preparing Pro Forma Income Statements with Different Assumptions T
ID: 2366627 • Letter: P
Question
Problem 14-18 Preparing Pro Forma Income Statements with Different Assumptions
Top executive officers of Leach Company, a merchandising firm, are preparing the next year's budget. The controller has provided everyone with the current year's projected income statement.
Current year
Sales Revenue $2,600,000
Cost of goods sold 1,690,000
Gross Profit 910,000
Selling & admin. Expenses 325,000
Net income $ 585,000
Cost of goods sold is usually 65% of sales revenue, and selling and administrative expenses are usually 10 % of sales plus a fixed cost of $65,000. The president has announced that the company's goal is to increase net income by 15 %.
Required:
The following items are independent of each other.
a. What percentage increase in sales would enable the company to reach its goal? Support your answer with a pro forma income statement.
b. The market may become stagnant next year, and the company does not expect an increase in sales revenue. The production manager believes that an improved production procedure can cut cost of goods sold by 2%. What else can the company do to reach its goal? Prepare a pro forma income statement illustrating your proposal.
c. The company decides to escalate its advertising campaign to boost consumer recognition, which will increase selling and administrative expenses to $405,000. With the increased advertising, the company expects sales revenue to increase by 15%. Assume that cost of goods sold remains a constant proportion of sales. Can the company reach its goal?
Explanation / Answer
The following items are independent of each other.
a. What percentage increase in sales would enable the company to reach its goal? Support your answer with a pro forma income statement.
Variable cost = 65% (COGS) + 10% (S&A) = 75%
Contribution Margin = 25%
Fixed cost = $65,000
Desired profit = $585,000 (Existing Net Income) x 1.15 = $672,750
Required sales = ($65,000 + $672,750) / 25%
= $2,691,000
Percent increase in sales = ($2,951,000 - $2,600,000) / $2,600,000
= $351,000 / $2,600,00 = 13.5%
Proforma Income Statement
Sales Revenue $2,951,000
Cost of goods sold $1,918,150
Gross Profit $1,032,850
Selling & admin. Expenses $360,100
Net income $672,750
b. The market may become stagnant next year, and the company does not expect an increase in sales revenue. The production manager believes that an improved production procedure can cut cost of goods sold by 2%. What else can the company do to reach its goal? Prepare a pro forma income statement illustrating your proposal.
Since market becomes stagnant, we have only option to reduce cost to achieve the target increase of 15% in net income. The cost of goods has already been reduced by 2%. Only variable Selling & Administrative expenses (10% of Sales revenue) may have the possibility of reduction.
Proforma Income Statement
Sales Revenue $2,600,000
Cost of goods sold 2.6M x 63% $1,638,000
Gross Profit $962,000
Selling & admin. Expenses
Fixed $65,000
Variable $224,250 1 $289,250
Net income $672,750
1 Variable Selling & Administrative expense = $962,000 - $65,000 - $672,750 = $224,250
Variable Selling & Administrative expense should be reduced to 8.625% instead existing 10%.
c. The company decides to escalate its advertising campaign to boost consumer recognition, which will increase selling and administrative expenses to $405,000. With the increased advertising, the company expects sales revenue to increase by 15%. Assume that cost of goods sold remains a constant proportion of sales. Can the company reach its goal?
Proforma Income Statement
Sales Revenue 2,600,000x1.15 $2,990,000
Cost of goods sold 2.99M x 65% $1,943,500
Gross Profit $1,046,500
Selling & admin. Expenses $405,000
Net income $641,500
The company wouldn't be able to achieve its goal of 15% i.e. S87,750 increase in net income. It would be able to increase net income by $56,500 ($641,500 - $585,000) i.e. 9.66% only.