Question

John Ranton, president and founder of Running Mate, could hardly contain his excitement over the operating results for his company's second year of operations. Running Mate is an online retailer of a GPS running watch that records distance, time, speed, heart rate, and a number of other statistics. Ranton's company does not manufacture the watches, but instead purchases them directly from the manufacturer based in China and resells them through its online shopping site.

During the first two years of operation, Ranton decided to hold the selling price of the watch constant at $100 per unit in an effort to attract business. He was also able to negotiate a deal with the supplier to hold Running Mates cost per watch constant at $80 per unit for the two years.

Operating expenses for each of the first two years of operation consist only of advertising expenses and the salaries paid to the website designer/administrator and the company's book keeper. Because Ranton is busy with his numerous other business ventures, the bookkeeper also looks after the day-to-day operations of Running Mate and has sole signing authority to make expenditures on the company's behalf. To motivate his website designer to create a web site that is easy to use and appealing to customers, Ranton decided to pay her a commission equal to 1% of annual sales in both 2015 and 2016. The salaries paid to the website administra tor and the bookkeeper were the same in both years and totalled $92,000. Annual advertising expenses of $8,000 were also the same in both years.

After reviewing the operating results for 2015 (shown below). Ranton roughly calculated the expected sales and expenses for 2016 based on anticipated sales of 10.000 watches at a price of $100 per unit and a cost of $80 per unit. He calculated expected operating expenses in 2016 based on the 2015 cost per unit of $13.75 ($ 1100008000 Based on his calculations (shown below). Ranton expected a 25% improvement in 2016 operating income, in keeping with the increase in unit sales. So, when Running Mate's bookkeeper provided Ranton with the actual results shown below for 2016, he was thrilled. Operating income had improved 50% compared to 2015 on sales growth of 25%.

Sales (units)..

Sales.....

Cost of goods sold.......

Gross margin.

Operating expenses............

Operating income..................................................

2015

8,000 $800.000 640,000

160000 $

50.000

2016

Expected

10,000 $1,000.000 800.000 200.000 137,500 $ 62,500

Actual

10.000 $1.000.000 800.000 125,000 $ 75,000

Ranton has always been an entrepreneur at heart but has no formal training in financial accounting or management accounting. He has always had the bookkeeper prepare annual financial statements.

Required:

1.

2.

Explain the nature of the error made by Ranton when calculating expected operating income for 2016.

Based on the information provided in the case, recalculate the expected results for 2016.

For Ranton's benefit. provide details on the specific items included in operating expenses (advertising, salaries, and commissions). Based on your calculations of the expected results for 2016, are the actual results for 2016 as good as Ranton originally thought? Explain.

Answer 1

1. Explain the nature of the error made by Ranton when calculating expected operating income for 2016.

Answer : The error made by Ranton when calculating the 2016 expected operating income was to treat all expenses as if they were variable. This is incorrect since the case indicates that advertising and the salaries of the website administrator and the bookkeeper are fixed costs. By including these costs in the calculation of 2015 operating expenses on a per unit basis, Ranton is effectively treating them as if they will vary in direct proportion with unit activity. This will lead to an overstatement of the expected amount of these expenses because they will not increase proportionately with sales activity.

2.

Based on the information provided in the case, recalculate the expected results for 2016.

For Ranton's benefit. provide details on the specific items included in operating expenses (advertising, salaries, and commissions). Based on your calculations of the expected results for 2016, are the actual results for 2016 as good as Ranton originally thought? Explain.

Answer :

The expected results for 2016, along with the 2015 actual results for comparison, are shown below.

Actual

2015

Expected

2016

Sales (units) .....................................................

8,000

10,000

Sales ......................................................................

$800,000

$1,000,000

Cost of goods sold:..........................................

640,000

800,000

Gross margin....................................................

160,000

200,000

Operating expenses

   Advertising....................................................

8,000

8,000

   Salaries..........................................................

92,000

92,000

   Commissions*...............................................

8,000

10,000

   Total operating expenses...............................

108,000

110,000

Operating income.............................................

$52,000

$90,000

The above shows that expected results for 2016 should have been $90,000. This assumes, as per the case, that advertising and salaries remain fixed at respectively, $8,000 and $92,000 per year. The only variable operating expense is the commission paid to the website designer / administrator based on 1% of total sales. Compared to the recalculated expected 2016 results the actual operating income of $75,000 no longer looks as good since it is $15,000 below the anticipated level.

3. Compare the expected operating expenses per your calculations in (2) to the actual results shown above for 2016. If you were Ranton, what follow-up questions would you have for the bookkeeper about 2016 operations?

Answer :

Comparison of expected and actual operating expenses in 2016:

            Expected expenses (per part 2 above) $110,000

            Actual expenses                                                          $135,000

            Difference                                                                   $ 25,000

Assuming no mistakes were made by the bookkeeper in preparing the 2016 financial statements Ranton needs to focus on the only variable operating expense – sales commissions paid to the website designer. If salaries ($92,000) and advertising ($8,000) truly are both fixed costs and did not change in 2016, the $25,000 difference between expected and actual operating expenses must be attributable to an increase in the amount of commissions actually paid. Perhaps a mistake was made in calculating the amount of the sales commissions but Ranton will want to get an answer.