Question

Top executive officers of Vernon Company, a merchandising firm, are preparing the next year’s budget. The controller has provided everyone with the current year’s projected income statement.

	Current Year
Sales revenue	$	2,400,000
Cost of goods sold		1,680,000
Gross profit		720,000
Selling & administrative expenses		317,000
Net income	$	403,000

  
Cost of goods sold is usually 70 percent of sales revenue, and selling and administrative expenses are usually 10 percent of sales plus a fixed cost of $77,000. The president has announced that the company’s goal is to increase net income by 15 percent.

Required

The following items are independent of each other.

1. Prepare a pro forma income statement. What percentage increase in sales would enable the company to reach its goal?

2. The market may become stagnant next year, and the company does not expect an increase in sales revenue. The production manager believes that an improved production procedure can cut cost of goods sold by 1 percent. Prepare a pro forma income statement still assuming the President's goal to increase net income by 15 percent. Calculate the required reduction in selling & administrative expenses to achieve the budgeted net income.

3. The company decides to escalate its advertising campaign to boost consumer recognition, which will increase selling and administrative expenses to $341,000. With the increased advertising, the company expects sales revenue to increase by 15 percent. Assume that cost of goods sold remains a constant proportion of sales. Prepare a pro forma income statement. Will the company reach its goal?

Answer 1

Part 1)

The pro forma income statement is prepared as follows:

Vernon Company
Pro forma Income Statement
Sales Revenue [(463,450 + 77,000)/20%]	2,702,250
Cost of Goods Sold (2,702,250*70%)	1,891,575
Gross Profit	810,675
Selling and Administrative Expenses (2,702,250*10% + 77,000)	347,225
Net Income [403,000*(1+15%)]	$463,450

20% indicates the contribution margin.

_____

The percentage increase in sales required to achieve target increase in income is calculated as below:

Percentage Increase in Sales = (2,702,250 - 2,400,000)/2,400,000*100 = 12.59%

_____

Part b)

The pro forma income statement is prepared as follows:

Vernon Company
Pro forma Income Statement
Sales Revenue	2,400,000
Cost of Goods Sold (2,400,000*70%*99%)	1,663,200
Gross Profit	736,800
Selling and Administrative Expenses	273,350
Net Income [403,000*(1+15%)]	$463,450

Now, we can calculate the amount of reduction in selling and administrative expenses as below:

Reduction in Selling and Administrative Expenses = 317,000 - 273,350 = $43,650

_____

Part c)

The pro forma income statement is given as below:

Vernon Company
Pro forma Income Statement
Sales Revenue [2,400,000*(1+15%)]	2,760,000
Cost of Goods Sold (2,760,000*70%)	1,932,000
Gross Profit	828,000
Selling and Administrative Expenses	341,000
Net Income	$487,000

As the net income in this case turns out to be $487,000 which is higher than the desired income of $463,450, the company will reach its goal.