John Ranton, president and founder of Running Mate, could hardly contain his excitement over the operating results for his company€™s second year of operations. Running Mate is an online retailer of a GPS running watch that records distance, time, speed, heart rate, and a number of other statistics. Ranton€™s company does not manufacture the watches, but instead purchases them directly from the manufacturer based in China and resells them through its online shopping site.

During the first two years of operation, Ranton decided to hold the selling price of the watch constant at $100 per unit in an effort to attract business. He was also able to negotiate a deal with the supplier to hold Running Mate€™s cost per watch constant at $80 per unit for the two years. Operating expenses for each of the first two years of operation consist only of advertising expenses and the salaries paid to the website designer/administrator and the company€™s book- keeper. Because Ranton is busy with his numerous other business ventures, the bookkeeper also looks after the day-to-day operations of Running Mate and has sole signing authority to make expenditures on the company€™s behalf. To motivate his website designer to create a website that is easy to use and appealing to customers, Ranton decided to pay her a commission equal to 1% of annual sales in both 2015 and 2016. The salaries paid to the website administrator and the bookkeeper were the same in both years and totalled $92,000. Annual advertising expenses of $8,000 were also the same in both years.

After reviewing the operating results for 2015 (shown below), Ranton roughly calculated the expected sales and expenses for 2016 based on anticipated sales of 10,000 watches at a price of $100 per unit and a cost of $80 per unit. He calculated expected operating expenses in 2016 based on the 2015 cost per unit of $13.75 ($110,000 ÷ 8,000). Based on his calculations (shown below), Ranton expected a 25% improvement in 2016 operating income, in keeping with the increase in unit sales. So, when Running Mate€™s bookkeeper provided Ranton with the actual results shown below for 2016, he was thrilled. Operating income had improved 50% compared to 2015 on sales growth of 25%.

Ranton has always been an entrepreneur at heart but has no formal training in financial accounting or management accounting. He has always had the bookkeeper prepare annual financial statements.
Required:
1. Explain the nature of the error made by Ranton when calculating expected operating income for 2016.
2. Based on the information provided in the case, recalculate the expected results for 2016. For Ranton€™s benefit, provide details on the specific items included in operating expenses (advertising, salaries, and commissions). Based on your calculations of the expected results for 2016, are the actual results for 2016 as good as Ranton originally thought? Explain.
3. Compare the expected operating expenses per your calculations in (2) to the actual results shown above for 2016. If you were Ranton, what follow-up questions would you have for the bookkeeper about 2016 operations?

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2016 2015 Expected Actual Sales (units) Sales Cost of goods sold Gross margin Operating expenses... Operating income 8,000 640000 800000 800,000 160,000 200,000 200,000 125,000 50,000 62500 75000 110,000 0 137500