Question

A simplified income statement for ABC firm (in million dollars):

	Income Statement	Normalized (Do you know how these percentages are calculated?)
Sales	$84,167	100%
Cost of Goods Sold (GOGS)	$42,428	50.4%
Gross Profit	$41,739	49.6%
Operating Expenses	$26,950	32.0%
Operating Income	$14,789	17.6%
All numbers are expressed in 1,000,000s

Key fact: Purchases are 80% of COGS

1) Besides reducing operating expenses, please identify two other means to improve the bottom line (i.e., to increase the operating income)?

Now, let’s perform a what-if analysis. In the first scenario, we analyze how an 8% reduction in the cost of purchased goods would impact operating profit?

2) How much is the current cost of purchased goods?

3) How much is the saving associated with an 8% reduction in cost of purchases?

4) Fill in the following income statement, reflecting 8% reduction in cost of purchases

	Income Statement	Normalized
Sales	$84,167	100%
Cost of Goods Sold (GOGS)
Gross Profit
Operating Expenses	$26,950	32.0%
Operating Income
All numbers are expressed in 1,000,000s

5) Based on the income statement table you computed above, a dollar saved in COGS translates into ________dollar (s) increase in operating income.

6). Based on the income statement table you computed above, an 8% reduction in cost of purchases can lead to ____________% increase in operating income.

Please show work!!

Answer 1

Answer 1

There are 3 items which can be altered to increase the operating Income

i) Increase the Sales

ii) Decrease the Cost of Goods Sold (COGS)

iii) Decrease the Operating Expenses

Hence except decreasing the Operating Expenses, we can increase the sales or decrease the COGS to increase the operating income

Answer 2

Current cost of purchased goods=80%*COGS =80%*42428=$33942.4

Answer 3

With 8% reduction in cost of purchased goods, cost savings =8%*33942.4=$2715.39

Answer 4

New COGS = Original COGS- Savings = 42428-2715.39=$39712.61

% COGS = COGS/Sales = 39712.61/84167=47.18%

Gross Profit = Sales-COGS=84167-39712.61=$44454.39

% Gross Profit = Gross Profit/ Sales=44454.39/84167 = 52.82%

Operating Income= Gross Profit - Operating Expenses = 44454.39-26950=$17504.39

% Operating Income = %Gross Profit-% Operating Expenses = 52.82%-32%=22.82%

Hence Table can be filled as below:

Answer 5

Saving in COGS = $2715.39

Increase in Operating Income = 17504.39-14789=$2715.39

Hence Increase per dollar saving of COGS = Increase in Operating Income/ Saving in COGS = 2715.39/2715.39=1

Hence $1 is the increase in Operating Income with a $1 saving in COGS

Answer 6

Original % of Operating Income = 17.6%

New % of Operating Income = 20.82%

Change in % = 20.82%-17.6%=3.22%

Hence 8% reduction in cost of purchased goods lead to increase in Operating Income of 3.22%.