You are examining the 2016 income statement of Ferintosh Pharmacies Ltd., a chain of pharmacies you’ve invested in. It’s a very competitive business and the company recently announced that it’s going to become a discount chain in an effort to improve its lackluster performance, indicated by its modest net income.

The new strategy means Ferintosh will cut prices and thereby reduce its gross margin percentage in an effort to increase volume. It will also try to control costs. You’re trying to predict the impact of the strategy on next year’s net income to decide whether this is a sensible strategy. From your analysis, if Ferintosh’s strategy stays the same in 2017, sales will grow by about 3 percent, interest will remain the same, and all other expenses will be at the same proportion of sales as last year. If Ferintosh implements the new strategy, you estimate that its gross margin will decrease by three percentage points but sales will increase by 10 percent. You also conclude that by implementing cost control measures Ferintosh will be able to limit the increase in salary and wages expense to 2 percent and general and administrative to 1.5 percent over 2016 levels. The advertising and promotion and interest expenses wouldn’t change. The depreciation expense would increase by 3 percent.

Ferintosh Pharmacies Ltd.

Income Statement

For the year ended December 31, 2016

Revenue……………………….                 $475,000

Cost of sales……………………….            296,875

Gross margin……………………….          178,125

Salaries and wages…………………         64,125

General and administrative……..       66,975

Advertising and promotion…………    19,000

Depreciation…………………                   19,475

Interest             …………………………         7,125

Income before taxes……………………     1,425

Income tax expense     ………………          256

Net income……………………….              $ 1,169

Required:

a. Prepare forecasted income statements for 2017 using the existing business strategy and the new discounting strategy.

b. Provide an assessment of the two strategies. Which do you think Ferintosh should pursue? Explain.

c. Explain the difference in gross margin between the two strategies. What amount of sales would be needed for the gross margin in the new strategy to be the same as in the old?