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1. A firm is able to sustain the same level of operations in terms of sales and administrative expenses but reduces its mater3. A company can manufacture a key component with annual requirement of 10,000 units with the following costs: Equipment = $3

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Answer #1

Ans 1. Let us first construct a simple P&L Statement.

Before reducing material costs, lets assume the below.

Sales 1000000
Cost of Goods Sold 600000
Gross Profit 400000
Administrative expenses 100000
Net Profit before taxes 300000

Now after reducing material cost by $50000, Cost of good sold becomes 600000-50000 = 550000. Also as per question the company retains same level of operations for sales and administrative expenses.

Sales 1000000
Cost of Goods Sold 550000
Gross Profit 450000
Administrative expenses 100000
Net Profit before taxes 350000

Answer to question sub question a - As you can see from the above mentioned example, as the materials cost are reduced, there is an increase in gross profit.Thus the profit leverage effect on gross-profits is an increase in gross profit by equal amount of materials cost reduced i.e $50,000 when sustaining same level of operations.

Answer to question sub question b - As you can see from the above mentioned example, as the materials cost are reduced, there is an increase in net profit before taxes.Thus the profit-leverage effect on net profits before taxes is an increase in net profits by equal amount of materials cost reduced i.e $50,000 when sustaining same level of operations.The profit after tax will change but it will have no effect on profit before taxes.

Answer 2. Let us construct the information in question again for calculation of the ratio.

Month Cost of Goods Sold Ending Inventory
January 185000 100000
February 900000 90000
March 950000 105000
April 800000 75000
May 950000 100000
June 850000 95000
July 550000 100000
August 1250000 250000
September 750000 85000
October 850000 110000
November 1000000 225000
December 1300000 250000
Total 10335000 1585000

Answer to sub question a -

Formula for Inventory Turnover ratio is = Cost of Goods Sold / Average Inventory.

So we need to calculate Average Inventory. To calculate that we need to divide all the closing inventories by 13 since we have 12 values of closing inventories per month and year end value of $200,000 given in the question. Thus,

Average Inventory = 1585000(This is the total of all 12 inventories calculated in table above)+200000(Year end Inventory)/13

                              = $137307.69.

Now using the value in above table we can get monthly Inventory Turnover ratio.

Month Cost of Goods Sold Ending Inventory

Inventory Turnover Ratio Monthly

= Cost of Goods Sold / Average Inventory.

January 185000 100000 =185000/137307.69 = 1.35 times
February 900000 90000 =900000/137307.69 = 6.56 times
March 950000 105000 =950000/137307.69= 6.92 times
April 800000 75000 =800000/137307.69= 5.83 times
May 950000 100000 =950000/137307.69= 6.92 times
June 850000 95000 =850000/137307.69= 6.19 times
July 550000 100000 =550000/137307.69= 4.01 times
August 1250000 250000 =1250000/137307.69= 9.10 times
September 750000 85000 =750000/137307.69= 5.46 times
October 850000 110000 =850000/137307.69= 6.19 times
November 1000000 225000 =1000000/137307.69= 7.28 times
December 1300000 250000 =1300000/137307.69= 9.47 times
Total 10335000 1585000

Answer to sub question b -

Formula for Inventory Turnover ratio is = Cost of Goods Sold / Average Inventory.

To Calculate Annual Inventory Turnover Ratio we need annual Cost of Goods Sold which is equal to $10,335,000( Total of all Costs of Goods Sold calculated in table above).

Also average inventory is $137307.69( Calculated in sub section a above).

Thus Annual Inventory Turnover Ratio = 10335000 / 137307.69

                                                      = 75.27 times.

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