Question

 Allen Products​ LP, wants to do a scenario analysis for the coming year. The pessimistic prediction for sales is $898,000​; the most likely amount of sales is $1,120,000​; and the optimistic prediction is $1,278,000.

​Allen's income statement for the most recent year is shown here

  
Sales revenue   $937,100
Less: cost of good sold  
Fixed   274,807
Variable   175,938
Gross profits   $486,355
Less: operating expenses  
Fixed   175,927
Variable   59,285
Operating profits   $251,143
Less: interest expense   29,050
Net profit before taxes   $222,093
Less: taxes (rate 25%)   55,523
Net profits after taxes   $166,570

.

a. 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: $ 274,807 of the cost of goods sold is​ fixed; the rest is variable.

$175,927 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​?

Answer 1

Percent of sales method :- In this method, expenses are considered as fixed percent of the sales which comes to :- 48.1% for cost of goods sold [ (450745/937100) *100] & 25.1% for variable operating expense [ (235212/937100) * 100].

Interest expense is fixed in nature as it does not change with change in the sales.

A.)

Particulars	Pessimistic	Most likely	Optimistic
Sales	$898,000	$1,120,000	$1,278,000
Less : Cost of goods sold	$431,938	$538,720	$614,718
(48.1% of sales)
Gross profits	$466,062	$581,280	$663,282
Less : Operating expenses	$225,398	$281,120	$320,778
(25.1% of sales)
Operating profits	$240,664	$300,160	$342,504
Less : Interest expenses	$29,050	$29,050	$29,050
Net profits before taxes	$211,614	$271,110	$313,454
Less : Tax @ 25%	$52,904	$67,778	$78,364
Net profits after taxes	$158,711	$203,333	$235,091

B.)

• Percent of sales method could result into overstatement of profits in Pessimistic scenario because there may be some expenses which are fixed in nature or have fixed elements. But in this method, we take fixed percent of sales as variable expense and due to less sales in pessimistic scenario, there might be less expenses deducted and which might result into Overstating of profits.
• Same way, in most likely and optimistic scenarios, there might be some expenses which are fixed in nature or or have fixed elements which does not change with the change in sales but we consider it as variable expense based on the percent of sales. Due to higher sales in most likely and optimistic scenarios, we might deduct higher expenses which might result into understatement of profits.

C.)

Particulars	Pessimistic		Most likely		Optimistic
Sales		$898,000		$1,120,000		$1,278,000
Less : Cost of goods sold
Fixed	$274,807		$274,807		$274,807
Variable (18.7745% of sales)	$168,595	$443,402	$210,274	$485,081	$239,938	$514,745
Gross profits		$454,598		$634,919		$763,255
Less : Operating expenses
Fixed	$175,927		$175,927		$175,927
Variable (6.3264% of sales)	$56,811	$232,738	$70,856	$246,783	$80,851	$256,778
Operating profits		$221,860		$388,136		$506,476
Less : Interest expenses		$29,050		$29,050		$29,050
Net profits before taxes		$192,810		$359,086		$477,426
Less : Tax @ 25%		$48,202		$89,771		$119,357
Net profits after taxes		$144,607		$269,314		$358,070

D.)

As explained in the part B, it is evident from the above solutions of part A & part C that in part A the profit is overstated in pessimistic scenario and understated in most likely and optimistic scenarios.

Thus, analyzing solution of part C states that it confirms the explanation of part B.