Question

1. A firm is able to sustain the same level of operations in terms of sales and administrative expenses but reduces its materials cost by $50,000 through smarter purchases, a) What is the profit-leverage effect on gross profits? b) What is the profit-leverage effect on profits before taxes? Tip: Construct a simple Profit & Loss Statement similar to the example during the lecture and use this in your analysis. 2. A retailer has an ending inventory of $200,000 as of December 31, 2017 and the following accounting information: MONTH January February March April May June July August September October November December COST OF GOODS SOLD (US$) 185,000 900,000 950,000 800,000 950,000 850,000 550,000 1,250,000 750,000 850,000 1,000,000 1,300,000 ENDING INVENTORY (US$) 100,000 90,000 105,000 75,000 100,000 95,000 100,000 250,000 85,000 110,000 225,000 250,000 a) Compute for the monthly inventory turnover ratio for each of the 12 months. b) Compute the annual inventory turnover ratio.

Answer 1

Ans 1. Let us first construct a simple P&L Statement.

Before reducing material costs, lets assume the below.

Sales	1000000
Cost of Goods Sold	600000
Gross Profit	400000
Administrative expenses	100000
Net Profit before taxes	300000

Now after reducing material cost by $50000, Cost of good sold becomes 600000-50000 = 550000. Also as per question the company retains same level of operations for sales and administrative expenses.

Sales	1000000
Cost of Goods Sold	550000
Gross Profit	450000
Administrative expenses	100000
Net Profit before taxes	350000

Answer to question sub question a - As you can see from the above mentioned example, as the materials cost are reduced, there is an increase in gross profit.Thus the profit leverage effect on gross-profits is an increase in gross profit by equal amount of materials cost reduced i.e $50,000 when sustaining same level of operations.

Answer to question sub question b - As you can see from the above mentioned example, as the materials cost are reduced, there is an increase in net profit before taxes.Thus the profit-leverage effect on net profits before taxes is an increase in net profits by equal amount of materials cost reduced i.e $50,000 when sustaining same level of operations.The profit after tax will change but it will have no effect on profit before taxes.

Answer 2. Let us construct the information in question again for calculation of the ratio.

Month	Cost of Goods Sold	Ending Inventory
January	185000	100000
February	900000	90000
March	950000	105000
April	800000	75000
May	950000	100000
June	850000	95000
July	550000	100000
August	1250000	250000
September	750000	85000
October	850000	110000
November	1000000	225000
December	1300000	250000
Total	10335000	1585000

Answer to sub question a -

Formula for Inventory Turnover ratio is = Cost of Goods Sold / Average Inventory.

So we need to calculate Average Inventory. To calculate that we need to divide all the closing inventories by 13 since we have 12 values of closing inventories per month and year end value of $200,000 given in the question. Thus,

Average Inventory = 1585000(This is the total of all 12 inventories calculated in table above)+200000(Year end Inventory)/13

                              = $137307.69.

Now using the value in above table we can get monthly Inventory Turnover ratio.

Month	Cost of Goods Sold	Ending Inventory	Inventory Turnover Ratio Monthly = Cost of Goods Sold / Average Inventory.
January	185000	100000	=185000/137307.69 = 1.35 times
February	900000	90000	=900000/137307.69 = 6.56 times
March	950000	105000	=950000/137307.69= 6.92 times
April	800000	75000	=800000/137307.69= 5.83 times
May	950000	100000	=950000/137307.69= 6.92 times
June	850000	95000	=850000/137307.69= 6.19 times
July	550000	100000	=550000/137307.69= 4.01 times
August	1250000	250000	=1250000/137307.69= 9.10 times
September	750000	85000	=750000/137307.69= 5.46 times
October	850000	110000	=850000/137307.69= 6.19 times
November	1000000	225000	=1000000/137307.69= 7.28 times
December	1300000	250000	=1300000/137307.69= 9.47 times
Total	10335000	1585000

Answer to sub question b -

Formula for Inventory Turnover ratio is = Cost of Goods Sold / Average Inventory.

To Calculate Annual Inventory Turnover Ratio we need annual Cost of Goods Sold which is equal to $10,335,000( Total of all Costs of Goods Sold calculated in table above).

Also average inventory is $137307.69( Calculated in sub section a above).

Thus Annual Inventory Turnover Ratio = 10335000 / 137307.69

                                                      = 75.27 times.