Question

Comparative income statements for South Drive Company for Year 2 and Year 1 are given below. Return on sales for South Drive is lower in Year 2 than in Year 1. What expense is causing this lower profitability?

	Year 2	Year 1
Sales	900,000	500,000
Cost of Goods Sold	(432,000)	(240,000)
Gross Profit on Sales	468,000	260,000
Wage Expense	(74,000)	(30,000)
Rent Expense	(90,000)	(50,000)
Operating Income	304,000	180,000
Interest Expense	(54,000)	(30,000)
Net Income	250,000	150,000

Group of answer choices

Wage expense

Interest expense

Cost of goods sold

Rent expense

Answer 1

Correct answer------------Wage expense

Working

I have used horizontal analysis to see which expense has mostly affected lowering of profitability.

Horizontal analysis
			Increase (Decrease)
	Year 2	Year 1	Amount	Percentage
Sales	$       900,000.00	$     500,000.00	$     400,000.00	80.00%
Cost of Goods Sold	$     (432,000.00)	$   (240,000.00)	$ (192,000.00)	80.00%
Gross Profit on Sales	$       468,000.00	$     260,000.00	$     208,000.00	80.00%
Wage Expense	$       (74,000.00)	$     (30,000.00)	$     (44,000.00)	146.67%
Rent Expense	$       (90,000.00)	$     (50,000.00)	$     (40,000.00)	80.00%
Operating Income	$       304,000.00	$     180,000.00	$     124,000.00	68.89%
Interest Expense	$       (54,000.00)	$     (30,000.00)	$     (24,000.00)	80.00%
Net Income	$       250,000.00	$     150,000.00	$     100,000.00	66.67%

Wages expense should have increase by 80% since 80% is increase in revenue. The wages increase by more than increase in sales hence it is the reason for decrease in profitability.