Question 3: Allen Products, Inc., wants to do a scenario analysis for the coming

Question

Question 3: Allen Products, Inc., wants to do a scenario analysis for the coming year. The pessimistic prediction for sales is $900,000; the most likely amount of sales is $1,125,000; and the optimistic prediction is $1,280,000. Allen’s income statement for the most recent year follows.

a. Use the percent-of-sales method, the income statement for December 31, 2015, and the sales revenue estimates to develop pessimistic, most likely, and optimistic pro forma income statements for the coming year.

b. Explain how the percent-of-sales method could result in an overstatement of profits for the pessimistic case and an 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 2015 costs: $250,000 of the cost of goods sold is fixed; the rest is variable. $180,000 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?

Explanation / Answer

a.

Allen Products INC

Income Statement for the year ended December 2015

Particulars

Given

Pessimistic

Most Likely

Optimistic

Sales Revenue

$937500

$900000

$1125000

$1280000

Less Cost of goods Sold(45%)

$421875

$405000

$506250

$576000

Gross Profits

$515625

$495000

$618750

$704000

Less Operating Expenses(25%)

$234375

$225000

$281250

$320000

Operating Profit

$281250

$270000

$337500

$384000

Less Interest Expense (3.2%)

$30000

$28800

$36000

$40960

Net Profits before Taxes

$251250

$241200

$301500

$343040

Less Taxes(rate=25%)

$62813

$60300

$75375

$85760

Net Profits after Taxes

$188437

$180900

$226125

$257280

b. In the Explained Percentage to sales method assumes that all costs are variable but in reality some 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 costs will not decrease. Just opposite happens in case of Optimistic and most likely as the sales increase the variable cost will increase but the Fixed portion of cost will not increase. The pattern results in understatement of costs in pessimistic case and overstatement of costs in optimistic and most likely case.

c.

Particulars

Pessimistic

Most Likely

Optimistic

Sales Revenue

$900000

$1125000

$1280000

Less Cost of goods Sold

Fixed

$250000

$250000

$250000

Variable (18.3%)

$164700

$205875

$234240

Gross Profits

$485300

$669125

$795760

Less Operating Expenses

$281250

$320000

Fixed

$180000

$180000

$180000

Variable (5.8%)

$52200

$65250

$74240

Operating Profit

$253100

$423875

$541520

Less Interest Expense

$30000

$30000

$30000

Net Profits before Taxes

$223100

$393875

$511520

Less Taxes(rate=25%)

$55775

$98469

$127880

Net Profits after Taxes

$167325

$295406

$383640

The Profit for the pessimistic Case is larger than in Part (a) than Part (c). The profits for Optimistic and Most Likely are higher in Part (c) than Part (a). The results confirms the results as stated in part (b)

Allen Products INC

Income Statement for the year ended December 2015

Particulars

Given

Pessimistic

Most Likely

Optimistic

Sales Revenue

$937500

$900000

$1125000

$1280000

Less Cost of goods Sold(45%)

$421875

$405000

$506250

$576000

Gross Profits

$515625

$495000

$618750

$704000

Less Operating Expenses(25%)

$234375

$225000

$281250

$320000

Operating Profit

$281250

$270000

$337500

$384000

Less Interest Expense (3.2%)

$30000

$28800

$36000

$40960

Net Profits before Taxes

$251250

$241200

$301500

$343040

Less Taxes(rate=25%)

$62813

$60300

$75375

$85760

Net Profits after Taxes

$188437

$180900

$226125

$257280

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