Question

Allen Products​ LP, 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 $ 1,118,000​; and the optimistic prediction is $ 1,288,000. ​Allen's income statement for the most recent year is shown here

Allen Products, Inc. Income Statement for
the Year Ended December 31, 2019  
Sales revenue   $937,400
Less: cost of good sold   436,828
Gross profits   $500,572
Less: operating expenses   245,599
Operating profits   $254,973
Less: interest expense   30,934
Net profit before taxes   $224,039
Less: taxes (rate 25%)   56,010
Net profits after taxes   $168,029

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 costs:

$252,497 of the cost of goods sold is​ fixed; the rest is variable. $193,516 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​?

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.

Complete the pro forma income statement for the year ending December​ 31, 2020 that is shown below​ (pessimistic scenario): ​ (Round the percentage of sales to one decimal place and the pro forma income statement accounts to the nearest​ dollar.)

Answer 1

Part a)

	Dec 31, 2019					Pessimistic	Most Likely	Optimistic
	$	% of sales				$	$	$
Sales Revenue	9,37,400	100%		A	Sales Revenue	9,00,000	11,18,000	12,88,000
Less: Cost of goods sold	4,36,828	47%		B= 47%*A	Less: Cost of goods sold	4,19,400	5,20,988	6,00,207
Gross Profits	5,00,572	53%		C= A-B	Gross Profits	4,80,600	5,97,012	6,87,793
Less: Operating Expenses	2,45,599	26%		D=26%*A	Less: Operating Expenses	2,35,800	2,92,916	3,37,456
Operating profits	2,54,973	27%		E=C-D	Operating profits	2,44,800	3,04,096	3,50,336
Less: Interest Expense	30,934	3%		F=3%*A	Less: Interest Expense	29,700	36,894	42,504
Net Profit before taxes	2,24,039	24%		G=E-F	Net Profit before taxes	2,15,100	2,67,202	3,07,833
Less taxes (25%)	56,010	6%		H=25%*G	Less taxes (25%)	53,775	66,801	76,958
Net Profit after taxes	1,68,029	18%		I=G-H	Net Profit after taxes	1,61,325	2,00,402	2,30,874

Part b)

A lot of expenses are fixed in nature either partially or wholly. The fixed expenses don't increase with increase in sales. However in percentage of sales method, all the expenses are assumed as variable wholly and increase with increase in sales. Hence even if the sales are higher for Most likely and optimistic scenario, due to increase in all the expenses in line with sales, the total profits after taxes are low and hence underestimated. And for Pessimistic scenario, even when the sales are low, due to low expenses, the total profits after taxes remain high and hence overestimated.

Part c)

	Dec 31, 2019					Pessimistic	Most Likely	Optimistic
	$	% of sales				$	$	$
Sales Revenue	9,37,400	100%		A	Sales Revenue	9,00,000	11,18,000	12,88,000
Less: Cost of goods sold	4,36,828			B=C+D	Less: Total Cost of goods sold (Fixed plus variable)	4,29,474	4,72,341	5,05,770
Fixed COGS	2,52,497			C	Fixed COGS	2,52,497	2,52,497	2,52,497
Variable COGS (Total-Fixed)	1,84,331	20%		D=20%*A	Variable COGS	1,76,977	2,19,844	2,53,273
Gross Profits	5,00,572			E=A-B	Gross Profits	4,70,526	6,45,659	7,82,230
Less: Operating Expenses	2,45,599			F=G+H	Less: Total Operating Expenses (Fixed plus variable)	2,43,521	2,55,633	2,65,079
Fixed Operating ex	1,93,516			G	Fixed Operating ex	1,93,516	1,93,516	1,93,516
Variable Operating ex (Total-Fixed)	52,083	6%		H=6%*A	Variable Operating ex	50,005	62,117	71,563
Operating profits	2,54,973			I=E-F	Operating profits	2,27,005	3,90,025	5,17,151
Less: Interest Expense	30,934			J	Less: Interest Expense	30,934	30,934	30,934
Net Profit before taxes	2,24,039			K=I-J	Net Profit before taxes	1,96,071	3,59,091	4,86,217
Less taxes (25%)	56,010			L=25%*K	Less taxes (25%)	49,018	89,773	1,21,554
Net Profit after taxes	1,68,029			M=K-L	Net Profit after taxes	1,47,054	2,69,319	3,64,663

Part d)

	Pessimistic	Most Likely	Optimistic
	$	$	$
Part b Profits after taxes	1,47,054	2,69,319	3,64,663
Part a Profits after taxes	1,61,325	2,00,402	2,30,874
Difference	-14,272	68,917	1,33,788

After comparing Part a and Part c, it is clearly visible that the profits were overestimated by $14,272 in Pessimistic scenario; the profits were underestimated by $68,917 & $133,788 in Most likely and Optimistic scenarios respectively. Clearly the observations in Part c get confirmed.