Question

Using sensitivity analysis Holly Company prepared the following budgeted income statement for the first quarter of 2018:

Holly Company is considering two options. Option 1 is to increase advertising by \(700 per month. Option 2 is to use better-quality materials in the manufacturing process. The better materials will increase the cost of goods sold to 45% but will provide a better product at the same sales price. The marketing manager projects either option will result in sales increases of 30% per month rather than 20%.

Requirements

1. Prepare budgeted income statements for both options, assuming both options begin in January and January sales remain \)8,000. Round all calculations to the nearest dollar.

2. Which option should Holly choose? Explain your reasoning.

Short answer

Holly should choose option 1.

Step-by-step solution

Preparation of budget under both options 

Option 1:

HOLLY COMPANY Budgeted Income Statement For the quarter ended March 31, 2018
	January	February	March	Total
Net sales revenue (30% increase per month)	$8,000	$10,400	$13,520	$31,920
Cost of Goods Sold (40% of sales)	3,200	3,840	4,608	11,648
Gross profit	4,800	6,560	8,912	20,272
S&A Expenses ($2,700 + 10% of sales)	3,500	3,740	4,052	11,292
Operating income	1,300	2,820	4,860	8,980
Income Tax Expense (30% of operating income)	390	846	1,458	2,694
Net Income	$910	$1,974	$3,402	$6,286

Preparation of budget under both options 

Option 2:

HOLLY COMPANY Budgeted Income Statement For the quarter ended March 31, 2018
	January	February	March	Total
Net sales revenue (30% increase per month)	$8,000	$10,400	$13,520	$31,920
Cost of Goods Sold (45% of sales)	3,600	4,680	6,084	14,364
Gross profit	4,400	5,720	7,436	17,556
S&A Expenses ($2,000 + 10% of sales)	2,800	2,960	3,152	8,912
Operating income	1,600	2,760	4,284	8,644
Income Tax Expense (30% of operating income)	480	828	1285	2,593
Net Income	$1,120	$1,932	$2,999	$6,051

Sensitivity Analysis

Holly should choose option 1 because under option 1 the company will earn $6,286.