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 on line 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 bookkeeper. 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 2017 and 2018. 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 2017 (shown below), Ranton roughly calculated the expected sales and expenses for 2018 based on anticipated sales of I 0,000 watches at a price of $100 per unit and a cost of $80 per unit. He calculated expected operating expenses in 2018 based on the 2017 cost per unit of S 13.50 ($108,000 / 8,000). Based on his calculations (shown below), Rant on expected a 25% improvement in 2018 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 2018, he was thrilled. Operating income had improved over 44% compared to 2017 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 2018.

2. Based on the information provided in the case, recalculate the expected results for 2018. 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 2018, are the actual results for 2018 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 2018. If you were Ranton, what follow-up questions would you have for the bookkeeper about 2018 operations?

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2018 Expected 2017 Actual Sales (units). Sales Cost of goods sold. Gross margin. Operating expenses. Operating income 8,000 $800,000 10,000 10,000 $1,000,000 800,000 $1,000,000 640,000 800,000 160,000 108,000 $ 52,000 200,000 135,000 65,000 200,000 125,000 75,000