Question

The Medford Mug Company is an old-line maker of ceramic coffee mugs. It imprints company
logos and other sayings on mugs for both commercial and wholesale markets. The firm has the
capacity to produce 50 million mugs per year, but the recession has cut production and sales in
the current year to 15 million mugs. The following table shows the operating statement for 2001:
MEDFORD MUG COMPANY
Income Statement
Year Ending 2001 ($ in Millions)
Sales (15 million @ $2) $ 30.0
Less Cost of goods sold
Variable cost (15 million at @0.50) (7.5)
Fixed cost (20.0) (27.5)
Gross margin $ 2.5
Less selling and administration (4.0)
Operating profit $ (1.5)
At the end of 2001, there was no ending inventory of finished goods.
The board of directors is very concerned about the $1.5 million operating loss. It hires an outside
consultant who reports back that the firm suffers from two problems. First, the president of the
company receives a fixed salary, and since she owns no stock, she has very little incentive worry
about company profits. The second problem is that the company has not aggressively marketed
its product and has not kept up with changing markets. The current president is 64 and the board
of directors makes her an offer to retire one year early so that they can hire a new president to
turn the firm around. The current president accepts the offer. To retire and the board immediately
hires a new president with a proven track record as a turnaround specialist.
The new president is hired with an employment contract that pays a fixed salary of $50,000 a
year plus 15 percent of the firm’s operating profits (if any). Operating profits are calculated using
absorption costing (i.e., gross margin income statement—like the one above). In 2002, the new
president doubles the selling and administration budget to $8 million (which includes the
president’s fixed salary of $50,000). He designs a new line of “politically correct” sayings to
imprint on the mugs and expands the inventory and the number of distributors handling the
mugs. Production is increased to 45 million mugs, and sales climb to 18 million mugs at $2 each.
Variable cost per mug remains at $0.50 per mug, and the fixed costs at $20 million in 2002.
At the end of 2002, the president meets with the board of directors and announces he has
accepted another job. He believes he has successfully gotten Medford Mug back on track and
thanks the board for giving him the opportunity. His new job is to turn around another struggling
company.
Required
a. Construct the gross margin income statement for 2002, and calculate the president’s bonus
for 2002.
b. Evaluate the performance of the new president in 2002. Did he do a good job from the
company’s perspective?  

Answer 1

a.	Gross Margin income statement and president Bonus
			$Million	$Million
	Selling Price	18m @ $2		36
	Variable Cost	18m @0.5	9
	Fixed Cost	20/45*18	8		Cost of 45 m is 20, and cost of goods sold is 8.
	Less: Total Cost			17
	Gross Margin			19
	Less Selling and Administration	(Given in Question)		8
	Operating Profit			11
	And President Commission	15% of Operating Profit 11		1.65
	Net Profit			9.35
b.	Evaluation
	As far as Operating profit is concerned, President helped company to bring it out of loss and have $11 m profit.
	Even after president commssion, company is having profit of $9.35M which is far better than loss of 1.5.
	Hence President has done a good job.