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.
1. A firm is able to sustain the same level of operations in terms of sales...
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