Question

Lemon Auto Wholesalers had sales of \(1,000,000 last year, and cost of goods sold represented 78 percent of sales. Selling and administrative expenses were 12 percent of sales. Depreciation expense was \)11,000 and interest expense for the year was \(8,000. The firm’s tax rate is 30 percent.

a. Compute earnings after taxes.

b. Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 14 percent of sales, sales can be increased to \)1,050,900. The extra sales effort will also reduce cost of goods sold to 74 percent of sales. (There will be a larger markup in prices as a result of more aggressive selling.) Depreciation expense will remain at \(11,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to \)15,800. The firm’s tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Carr’s suggestions for Lemon Auto Wholesalers. Will her ideas increase or decrease profitability?

Short answer

1. Earnings after taxes: $56,700
2. Earnings after taxes: $69,516

The profitability of the company increases after following the idea of Ms. Carr.

Step-by-step solution

Calculation of earnings after tax

Sales	$1,000,000
Less: Cost of sales (78% of sales)	780,000
Gross profit	220,000
Less: Selling and administrative expenses (12% of sales)	120,000
Less: Depreciation expense	11,000
Operating profit	89,000
Less: Interest expenses	8,000
Earnings before tax	81,000
Less: Tax expense ($81,000 x 30%)	24,300
Earning after tax	56,700

Calculation of earnings after tax when the idea of Ms. Carr is followed

Sales	$1,050,900
Less: Cost of sales (74% of sales)	777,666
Gross profit	273,234
Less: Selling and administrative expenses (14% of sales)	147,126
Less: Depreciation expense	11,000
Operating profit	115,108
Less: Interest expenses	15,800
Earnings before tax	99,308
Less: Tax expense ($120,326 x 30%)	29,792
Earning after tax	69,516

Profitability will increase after following Ms. Carr's ideas.