A contractor estimates their annual revenue will be $2,400,000 with a gross profit margin of 18%. Fixed costs are projected at $175,000 and variable costs at 65% of revenue. What is the projected net income?
Correct Answer
D) $257,000
Revenue $2,400,000 - Variable costs ($2,400,000 × 65% = $1,560,000) - Fixed costs $175,000 = $665,000. However, with 18% gross profit: $2,400,000 × 18% = $432,000 gross profit - $175,000 fixed costs = $257,000 net income.
Why This Is the Correct Answer
The correct approach is to use the gross profit margin to calculate gross profit ($2,400,000 × 18% = $432,000), then subtract fixed costs to get net income. Net income = Gross profit - Fixed costs = $432,000 - $175,000 = $257,000. The variable cost percentage given is already factored into the gross profit margin, so using both would be double-counting costs.
Why the Other Options Are Wrong
Option A: $432,000
This amount doesn't follow the proper calculation sequence and likely represents an error in applying the percentages or mixing different calculation methods.
Option B: $225,000
This appears to be calculated by subtracting variable costs and fixed costs separately from revenue, which double-counts the costs since the gross profit margin already accounts for all costs of goods sold.
Option C: $367,000
This represents the gross profit ($432,000) before subtracting fixed costs. You cannot stop at gross profit - you must subtract fixed costs to arrive at net income.
Memory Technique
Remember 'GPS': Gross Profit minus Overhead (fixed costs) = Net Profit. Don't double-count costs when gross margin is already provided.
Reference Hint
Business and Finance chapter covering profit and loss statements, income statement calculations, and the relationship between gross profit, fixed costs, and net income
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