Question

Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own; rather, it relies completely on independent sales agents to market its products. These agents are paid a sales commission of 15% for all items sold.

Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year as follows:

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales				$	21,500,000
Manufacturing expenses:
Variable	$	9,675,000
Fixed overhead		3,010,000			12,685,000
Gross margin					8,815,000
Selling and administrative expenses:
Commissions to agents		3,225,000
Fixed marketing expenses		150,500	*
Fixed administrative expenses		2,020,000			5,395,500
Net operating income					3,419,500
Fixed interest expenses					752,500
Income before income taxes					2,667,000
Income taxes (30%)					800,100
Net income				$	1,866,900

*Primarily depreciation on storage facilities.

As Barbara handed the statement to Karl Vecci, Pittman’s president, she commented, “I went ahead and used the agents’ 15% commission rate in completing these statements, but we’ve just learned that they refuse to handle our products next year unless we increase the commission rate to 20%.”

“That’s the last straw,” Karl replied angrily. “Those agents have been demanding more and more, and this time they’ve gone too far. How can they possibly defend a 20% commission rate?”

“They claim that after paying for advertising, travel, and the other costs of promotion, there’s nothing left over for profit,” replied Barbara.

“I say it’s just plain robbery,” retorted Karl. “And I also say it’s time we dumped those guys and got our own sales force. Can you get your people to work up some cost figures for us to look at?”

“We’ve already worked them up,” said Barbara. “Several companies we know about pay a 7.5% commission to their own salespeople, along with a small salary. Of course, we would have to handle all promotion costs, too. We figure our fixed expenses would increase by $3,225,000 per year, but that would be more than offset by the $4,300,000 (20% × $21,500,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,225,000 cost follows:

Salaries:
Sales manager	$	134,375
Salespersons		806,250
Travel and entertainment		537,500
Advertising		1,746,875
Total	$	3,225,000

“Super,” replied Karl. “And I noticed that the $3,225,000 equals what we’re paying the agents under the old 15% commission rate.”

“It’s even better than that,” explained Barbara. “We can actually save $98,900 a year because that’s what we’re paying our auditors to check out the agents’ reports. So our overall administrative expenses would be less.”

“Pull all of these numbers together and we’ll show them to the executive committee tomorrow,” said Karl. “With the approval of the committee, we can move on the matter immediately.”

Required:

1. Compute Pittman Company’s break-even point in dollar sales for next year assuming:

a. The agents’ commission rate remains unchanged at 15%.

b. The agents’ commission rate is increased to 20%.

c. The company employs its own sales force.

2. Assume that Pittman Company decides to continue selling through agents and pays the 20% commission rate. Determine the dollar sales that would be required to generate the same net income as contained in the budgeted income statement for next year.

3. Determine the dollar sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force.

4. Compute the degree of operating leverage that the company would expect to have at the end of next year assuming:

a. The agents’ commission rate remains unchanged at 15%.

b. The agents’ commission rate is increased to 20%.

c. The company employs its own sales force.

Use income before income taxes in your operating leverage computation.

Answer 1

448 449 450 15% Commission 21,500,000 20% Commission 21,500,000 100% Own sales force 100% 21,500,000 100% 451 452 453 9,675,000 3,225,000 12,900,000 8,600,000 9,675,000 4,300,000 13,975,000 7,525,000 454 455 60.00% 40.000% 9,675,000 1,612,500 11,287,500 10,212,500 65.00% 35.000% 52.50% 47.500% 457 Sales Variable expenses: Manufacturing Commissions Total variable expenses Contribution margin Fixed expenses: Manufacturing overhead. Marketing Administrative Interest Total fixed expenses Income before income taxes Income taxes (30%) Net income 460 461 3,010,000 150,500 2,020,000 752,500 5,933,000 2,667,000 800,100 1,866,900 3,010,000 150,500 2,020,000 752,500 5,933,000 1,592,000 477,600 1,114,400 3,010,000 3,375,500 1,921,100 752,500 9,059,100 1,153,400 346,020 807,380 462 463 464 465 466 a 467 468 break-even point in dollar sales Fixed Expenses Conribution Margin Ratio 5,933,000 40.000% 470 471 472 break-even point in dollar sales 14,832,500

break-even point in dollar sales Fixed Expenses Conribution Margin Ratio 475 b 476 477 478 479 5,933,000 35.000% 480 break-even point in dollar sales 16,951,429 break-even point in dollar sales 481 482 483 484 C 485 486 487 488 489 Fixed Expenses Conribution Margin Ratio 9,059,100 47.50% 490 break-even point in dollar sales 19,071,789 491

2 break-even point in dollar sales 494 Fixed expenses + Target Profit Conribution Margin Ratio 495 5933000+1866900 497 0.35000 499 7,799,900 0.35000 500 break-even point in dollar sales 22285429 504 505 3 X = Total sales revenue 508 .65 X + 5,933,000 = 5250 X + 9,059,100 509 .125X = 3126100 512 513 514 3,126,100 0.125 515 X = 25,008,800

517 518 519 Thus, at a sales level of $25,8,800 either plan would yield the same income before taxes and net income. Below this sales level, the commission plan would yield the largest net income; above this sales level, the sales force plan would yield the largest net income. 520 521 ,bc Contribution margin Income before taxes Degree of operating leverage 15% Commission 20% Commission 8,600,000 7,525,000 2,667,000 1,592,000 3.22 4.73 Own sales force 10,212,500 1,153,400 8.85 524 525