4. Kent wants to know which of the profit numbers he should be concerned with. H
ID: 2782144 • Letter: 4
Question
4. Kent wants to know which of the profit numbers he should be concerned with. Help Kent by explaining what each type of profit (gross profit, operating profit, and net profit) tells us about how the company is doing. 5. Startupanddie runs into a bad stretch and becomes unprofitable. Kent, ever the alarmist, is considering going to the CEO to tell her that the company needs to declare bankruptcy because they are unprofitable. Explain to Kent why he is wrong and what number he needs to watch closely to be sure that the company doesn’t go bankrupt. 6. Startupanddie sells electronic widgets for $50 each. Each widget costs them $25 to buy from their manufacturer. Their annual fixed costs include $500,000 in administrative salaries, $1,000,000 in marketing and sales costs, and $50,000 in interest expense. How big does Startupanddie need to be to cover its fixed costs? a. In units b. In dollars
Explanation / Answer
4.
Gross profit indicates the gross margin of any business and is calculated by deducting the cost of goods sold from the revenues.
Operating profit is calculated by deducting the business expenses from the gross profit. Expenses such as general administration expenses, depreciation etc. are deducted to arrive at the operating profit level.
For calculating the net profit, the interest expenses and taxes are deducted from the operating profit.
Ken should ideally focus on operating profit to understand how the company is doing because if the operating profit is positive then the company would be able to service its debts, if any, and sustain its business.
5.
Ken is wrong as net profit is not a good indicator. Instead he should focus on cash flow from operations. If cash flow from operation is positive, then the company can sustain its business, service its debt even if it is unprofitable.
6.
Annual fixed costs = $500,000 + $1,000,000 + $50,000 = $1,550,000
Total contribution per product = $50-$25 = $25
No. of units to be sold to cover fixed costs = $1,550,000 / $25 = 62000
Revenue = 62000 * $50 = $31,00,000
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