Question

CASE 5–33 Cost Structure; Break-Even and Target Profit Analysis LO5–4, LO5–5, LO5–6

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 for next year as follows:
Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales        $16,000,000
Manufacturing expenses:       
Variable    $7,200,000   
Fixed overhead       2,340,000         9,540,000
Gross margin        6,460,000
Selling and administrative expenses:       
Commissions to agents    2,400,000   
Fixed marketing expenses    120,000*   
Fixed administrative expenses       1,800,000         4,320,000
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% × $16,000,000) that we would avoid on agents’ commissions.”

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The breakdown of the $2,400,000 cost follows:
Salaries:   
Sales manager    $   100,000
Salespersons    600,000
Travel and entertainment    400,000
Advertising       1,300,000
Total    $2,400,000

“Super,” replied Karl. “And I noticed that the $2,400,000 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 $75,000 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.”

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

    The agents’ commission rate remains unchanged at 15%.
    The agents’ commission rate is increased to 20%.
    The company employs its own sales force.

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 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