Question

CASE 2-33 Cost Structure; Break-Even and Target Profit Analysis LO2-4, LO2-5, LO2-6 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 Page 12 for next year as follows Pittman Company Budgeted Income Statement For the Year Ended December 31 $16,000,000 Sales Manufacturing expenses $7,200,000 Variable Fixed overhead 2.340,000 9.540,000 Gross margin 6,460,000 Selling and administrative expenses: Commissions to agents $2,400,000 120,000 Fixed marketing expenses Fixed administrative expenses 4.320,000 1.800,000 Net operating income 2,140,000 Fixed interest expenses 540,000 Income before income taxes 1,600,000 Income taxes (30 %) 480,000 Net income 1,120,000 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 $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% x $16,000,000) that we would avoid on agents' commissions."

Answer each question as if you were a consultant hired by the Pittman Company and are presenting to the Executive Committee as indicated in the case study.

For each answer explain the terminology and concepts used. For example, in #1 rather than just give the breakeven for each scenario, explain the change in the volume of sales, explain the calculation - this is a professional report from a consultant to an executive committee.

Use outside sources when necessary BUT MAKE SURE YOU CITE THEM!

When giving a recommendation, back it up with numbers.

This particular answer should be an executive committee report that is no more than 4 pages in length.

Answer 1

The data in the statements below are in thousands.

	15% Commission						20% Commission						Own Sales Force
Sales	$	16000		100	%		$	16000		100	%		$	16000		100.0	%
Variable expenses:
Manufacturing		7200						7200						7200
Commissions (15%, 20%, 7.5%)		2400						3200						1200
Total variable expenses		9600		60.0	%			10400		65.0	%			8400		52.5	%
Contribution margin		6400		40.0	%			5600		35.0	%			7600		47.5	%
Fixed expenses:
Manufacturing overhead		2340						2340						2340
Marketing		120						120						2520
Administrative		1800						1800						1725
Interest		540						540						540
Total fixed expenses		4800						4800						7125
Income before income taxes		1600						800						475
Income taxes (30%)		480						240						142.50
Net income	$	1120					$	560					$	332.50

120000+2400000 = 2520000 1800000-75000 = 1725000

Part 1 A

Dollar sales to break even= fixed expenses/CM ratio = 4800000/0.400 = $12000000

Part 1 B

Dollar sales to break even= fixed expenses/CM ratio = 4800000/0.350 = $13714286

Part 1 C

Dollar sales to break even= fixed expenses/CM ratio = 7125000/0.475 = $15000000

Part 2

In order to generate a $1742300 net income, the company must generate $2489000 in income before taxes

Dollar sales to attain target= target income before taxes + fixed expenses / contribution margin ratio = (1600000+4800000)/ 0.350 = $18285714

Part 3

X = total sales revenue

0.650x+4800000 = 0.525x+7125000

0.125x =2325000

X = $18600000

Part 4

	15% Commission	20% Commission	Own Sales Force
Contribution margin (Part 1) (a)	6400000	5600000	7600000
Income before taxes (Part 1) (b)	1600000	800000	475000
Degree of operating leverage: (a) ÷ (b)	4.00	7.00	16.00

Part 5

The company make use of Own Sales Force as it give higher contribution margin and higher DOL.