Question

Pro forma income statement-Scenario analysis Allen Products LP, wants to do a scenario analysis for the coming year. The pessimistic prediction for sales is $909,000; the most likely amount of sales is $1,132,000; and the optimistic prediction is $1,286,000. Allens income statement for the most recent year is shown below. Use the percent-of-sales method, the income statement for December 31, 2019, and the sales revenue estimates to develop pessimistic, most likely, and optimistic pro forma income statements for the coming year b. Explain how this method could result in overstatement of profits for the pessimistic case and understatement of profits for the most likely and optimistic cases c. Restate the pro forma income statements prepared in part a. to incorporate the following assumptions about the 2019 costs: $237,067 of the cost of goods sold is fixed; the rest is variable. $208,530 of the operating expenses is fixed, the rest is variable. All the interest expense is fixed. d. Compare your findings in part c. to your findings in part a. Do your observations confirm your explanation in part b?

Use the ​percent-of-sales method, the income statement for December​ 31, 2019, and the sales revenue estimates to develop​pessimistic, most​ likely, and optimistic pro forma income statements for the coming year.

Complete the pro forma income statement for the year ending December​ 31, 2020 that is shown below​ (pessimistic scenario): ​(Round the percentage of sales to one decimal place and the pro forma income statement accounts to the nearest​ dollar.)

Allen Products, Inc. Income Statement for
the Year Ended December 31, 2019  
Sales revenue   $937,800
Less: cost of good sold   410,756
Gross profits   $527,044
Less: operating expenses   256,957
Operating profits   $270,087
Less: interest expense   29,072
Net profit before taxes   $241,015
Less: taxes (rate 25%)   60,254
Net profits after taxes   $180,761

  
Sales revenue   $937,800
Less: cost of good sold  
Fixed   237,067
Variable   173,689
Gross profits   $527,044
Less: operating expenses  
Fixed   208,530
Variable   48,427
Operating profits   $270,087
Less: interest expense   29,072
Net profit before taxes   $241,015
Less: taxes (rate 25%)   60,254
Net profits after taxes   $180,761

Answer 1

Answer-a:

Sales revenue Less: Cost of goods sold Gross Profit Less: Operating expenses Operating profits Less: Interest Expense Net profit before taxes Less: Taxes (rate = 25%) Net profit after taxes Proforma Income Statement Allen Products LP Pessimistic Most Likely Optimistic $ 909,000 $ 1,132,000 $ 1,286,000 398,142 495,816 563,268 510,858 636,184 722,732 249,066 310,168 352,364 261,792 326,016 370,368 28,179 35,092 39,866 233,613 290,924 330,502 58,403 72,731 82,626 $ 175,210 $ 218,193 $ 247,877

Working Note:-

Income Statement for the Year Ended December 31, 2019 Dollars Percentage Sales revenue 937,800 100% Less: Cost of goods sold 410,756 43.80% Gross Profit 527,044 56.20% Less: Operating expenses 256,957 27.40% Operating profits 270,087 28.80% Less: Interest Expense 29,072 3.10% Net profit before taxes 241,015 25.70% Less: Taxes (rate = 25%) 60,254 6.43% Net profit after taxes 180,761 19.28%

Answer-b:

The simple percent-of-sales method assumes that all costs are variable. In reality some of the expenses will be fixed. In the pessimistic case this assumption causes all costs to decrease with the lower level of sales when in reality the fixed portion of the costs will not decrease. The opposite occurs for the optimistic forecast since the percent-of-sales assumes all costs
increase when in reality only the variable portion will increase. This pattern results in an understatement of costs in the pessimistic case and an overstatement of profits. The opposite occurs in the optimistic scenario.

Answer-c:

Proforma Income Statement Allen Products LP Pessimistic Most Likely Optimistic Sales revenue $ 909,000 $ 1,132,000 $ 1,286,000 Less: Cost of goods sold: Fixed 237,067 237,067 237,067 Variable (18.52%) $ 168,347 $ 209,646 $ 238,167 Gross Profit $ 503,586 $ 685,287 $ 810,766 Less: Operating expenses: Fixed 208,530 208,530 208,530 Variable (5.16%) $ 46,904 $ 58,411$ 66,358 Operating profits $ 248,152 $ 418,345 $ 535,878 Less: Interest Expense 29,072 29,072 29,072 Net profit before taxes $ 219,080 $ 389,273 $ 506,806 Less: Taxes (rate = 25%) $ 54,770 $ 97,318 $ 126,702 Net profit after taxes $ 164,310 $ 291,955 $ 380,105

Cost of goods sold variable percentage = ($410,756 - $237,067) / $937,800
Operating expense variable percentage  ($256,967 - $208,530) / $937,800

Answer-d:

The profits for the pessimistic case are larger in part (a) than in part (c). For the optimistic case, the profits are lower in part (a) than in part (c). This outcome confirms the results as stated in part (b).