Deluxe Toys Inc. produces electronic toys for 2-12 year olds. The most-recent income statement for Deluxe is given below:

CFA Level II Equities
#1

Deluxe Toys Inc. produces electronic toys for 2-12 year olds. The most-recent income statement for Deluxe is given below:

Revenues 1500 Cost of goods sold 630 Selling expenses 120 Administrative expense 330 Operating profit 420

Ben Sharpe, Analyst with AP Partners, is forecasting Deluxe’s operating profit for the next fiscal year. Sharpe believes that a new sales tax of 10% is going to be imposed on electronic toys. Sharpe also believes that cost of goods sold and selling expenses are a fixed percentage of sales, while administrative expenses are fixed. Deluxe is expected to pass on the entire cost of the sales tax to the consumer. The price elasticity of demand for Deluxe’s toys is 0.75 (e.g., volume will decrease by 7.5% when the effective price increases by 10%.) Forecasted operating margin for the next year is closest to:

A)

21%

B)

26%

C)

23%

Correct is C.

New sales (including tax) = 1500 × (1 - 0.075) × (1 + 0.10) = 1526.25

Sales tax = (1526.25 / 1.10) × 10% = 138.75

Net sales = 1387.50

Due to 7.5% reduction in units sold, COGS will decline to 630 × (1 - 0.075) = 582.75

Selling expenses currently are 8% of sales. New selling expense = 1526.25 × 0.08 = 122.10

Administrative expenses are fixed at 330.

Operating profit = 1387.50 - 582.75 - 122.10 - 330 = $352.65, which is 23.11% of $1526.25.

My questions:

It is said that COGS are fixed % of sales. So, what are they doing then? why 630*0.925??? Isn’t it 1) get that COGS is 42% of sales, then get new sales and get 42% of that!

Second, What are they doing with sales tax? why Sales tax = (1526.25 / 1.10) × 10% = 138.75 and not 1526*0.1 ? why they divide it by 1.1?

Thank you!

#2

630*.925 is calculated because there’s a reduction of units sold by 7.5%. The question is wordy so its difficult to understand. Deluxe is passing the sales tax to the consumer, which reduces the units.

#3

1526.25 is the sum with sales tax included. The sales tax would not be 10% from that (as you would double count), it would rather be 10% from the taxable base of the sale. To make it a simpler example: If something was priced 1000 pre-sales tax and the sales tax was 10%, then the final price would be 1100 (1000 + 10%*1000). To calculate the sales tax, you cannot multiply 10% by 1100, you need to remove the tax first, hence you divide by 1.1 (which is 100% base + 10% sales tax) to go back to the taxable base of 1000, and only then you multiply by 10%, to get 100 sales tax.