Question: John Krog is president, chairman of the
John Krog is president, chairman of the board, production supervisor, and majority
shareholder of Krog’s Metalfab, Inc. He formed the company in 1991 to manufacture custom-built aluminum storm windows for sale to contractors in the greater Chicago area. Since that time the company has experienced tremendous growth and currently operates two plants: one in Chicago, the main production facility, and a smaller plant in Moline, Illinois. The company now produces a wide variety of metal windows, framing materials, ladders, and other products related to the construction industry. Recently the company developed a new line of bronze-finished storm windows, and initial buyer reaction has been quite favorable. The company’s future seemed bright, but on January 3, 2016, a light fixture overheated causing a fire that virtually destroyed the entire Chicago plant. Three days later, Krog had moved 50 percent of his Chicago workforce to the Moline plant. Workers were housed in hotels, paid overtime wages, and provided with bus transportation home on weekends. Still, the company could not meet delivery schedules because of reduced operating capacity, and total business began to decline. At the end of 2016, Krog felt that the worst was over. A new plant had been leased in Chicago, and the company was almost back to normal. Finally, Krog could turn his attention to a matter of considerable importance: settlement with the insurance company. The company’s policy stipulated that the building and equipment loss be calculated at replacement cost. This settlement had been fairly straightforward, and the proceeds had aided the rapid rebuilding of the company. A valued feature of the insurance policy was “lost profit†coverage. This coverage was to “compensate the company for profits lost due to reduced operating capacity related to fire or flood damage.†The period of “lost profit†was limited to 12 months. Interpreting the exact nature of this coverage proved to be difficult. The insurance company agreed to reimburse Krog for the overtime premium, transportation, and housing costs related to operating out of the Moline plant. These expenses obviously minimized the damages related to the 12 months of lost or reduced profits. But was the company entitled to any additional compensation? Krog got out the latest edition of Construction Today. According to this respected trade journal, sales of products similar to products produced by Krog’s Metalfab had increased by 7 percent during 2016. Krog felt that were it not for the fire, his company could also have increased sales by this percentage. Income statement information is available for 2015 (the year prior to the fire) and 2016 (the year during which the company sustained “lost profitâ€). The expenses in 2016 include excess operating costs of $250,000. Krog has documentation supporting these items, which include overtime costs, hotel costs, meals, and such related to operating out of Moline. The insurance company is quite willing to pay for these costs since they reduced potential lost profit. The chief accountant at Krog, Peter Newell, has estimated lost profit to be only $34,184. Thus, he does not feel that it’s worthwhile spending a lot of company resources trying to collect more than the $250,000. Peter arrived at his calculation as follows:
Sales in 2015……………………………………………$5,091,094
Predicted sales in 2016, assuming
a 7% increase……………………………………………$5,447,471
Actual sales in 2016…………………………………….3,857,499
(A) Lost sales………………………………………………1,589,972
(B) Profit in 2015 as a percentage of 2015
sales ($109,495 ÷ 5,091,094)……………………………..0215
Lost profit (A × B)…………………………………….$ 34,184
Required:
a. Mr. Krog is not convinced by Peter’s analysis and has turned to you, an outside consultant, to provide a preliminary estimate of lost profit. Using the limited information contained in the financial statements for 2015 and 2016, estimate lost profits. (Hint: You can proceed as follows.)
Step 1: Determine the level of fixed and variable costs in 2015 as a function of sales. You can use account analysis, the high-low method, or regression if you are familiar with that technique. If you use account analysis, assume that cost of goods sold and selling expense are variable costs and administrative expense is a fixed cost.
Step 2: Predict what sales would have been in 2016 if there was no fire. Using this level of sales and the fixed and variable cost information from Step 1, estimate what profit would have been in 2016.
Step 3: The difference between actual profit in 2016 and the amount estimated in Step 2 is lost profit.
b. Based on your preliminary analysis, do you recommend that Mr. Krog aggressively pursue a substantial claim for lost profit?
c. What is the fundamental flaw in Peter Newell’s analysis?
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Krog's Metalfab Income from Operations, 2015 and 2016 2015 January February March Аpril May June July August September October November December Total Sales $501,260 $349,260 $361,250 $303,685 $435,650 $511,650 $561,625 $603,210 $421,210 $331,025 $330,009 $381,260 $5,091,094 Less: Cost of goods 422,007 23,590 sold 392,036 441,570 334,030 321,131 371,140 406,065 440,620 370,434 332,255 333,134 354,053 4,518,475 Selling expense Administrative 21,200 15,720 15,535 13,300 18,425 21,472 25,020 17,795 14,383 14,301 16,383 217,124 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 246,000 еxpense Total expense 433,736 477,790 370,065 354,931 410,065 448,037 466,097 486,140 408,729 367,138 367,935 390,936 4,981,599 Income from operations $ 67,524 ($128,530) ($ 8,815) ($ 51,246) $ 25,585 $ 63,613 $ 95,528 $117,070 $ 12,481 ($ 36,113) ($ 37,926) ($ 9,676) $ 109,495 2016 January February March Аpril May June July August September October November December Total Sales $447,252 $236,362 $291,370 $216,265 $278,165 $316,441 $357,662 $453,245 $363,772 $315,427 $264,273 $317,265 $3,857,499 Less: Cost of goods sold 327,776 343,590 14,112 357,880 362,254 16,005 320,800 343,583 14,149 4,131,254 171,744 395,445 311,800 330,720 301,232 395,442 340,732 Selling expense Administrative 19,340 10,900 13,110 10,105 12,582 15,760 19,583 14,072 12,026 expense 22,300 23,515 23,910 24,650 23,745 24,790 23,745 23,522 23,670 22,791 22,709 22,990 282,337 Total expense 437,085 $346,215 $367,740 $335,987 $364,103 $382,492 397,385 438,547 401,929 377,595 355,535 380,722 4,585,335 Income from operations $ 10,167 ($109,853) ($ 76,370) (s119,722) ($ 85,938) ($ 66,051) ($ 39,723) $ 14,698 ($ 38,157) ($ 62,168) ($ 91,262) ($ 63,457) ($ 727,836)
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