Question

Lionel Corporation manufactures pharmaceutical products sold through a network of sales agents in the United States and Canada. The agents are currently paid an 18% commission on sales; that percentage was used when Lionel prepared the following budgeted income statement for the fiscal year ending June 30, 2019:

Lionel Corporation Budgeted Income Statement For the Year Ending June 30, 2019 ($000 omitted) $ 29,900 Sales Cost of goods sold Variable $ 13,455 3,588 Fixed 17,043 $ 12,857 Gross profit Selling and administrative costs Commissions $ 5,382 897 Fixed advertising cost 8,671 $ 4,186 Fixed administrative cost 2,392 Operating income Fixed interest cost 748 $ 3,438 1,031 Income before income taxes Income taxes (30%) $ 2,407 Net income

Since the completion of the income statement, Lionel has learned that its sales agents are requiring a 5% increase in their commission rate (to 23%) for the upcoming year. As a result, Lionel’s president has decided to investigate the possibility of hiring its own sales staff in place of the network of sales agents and has asked Alan Chen, Lionel’s controller, to gather information on the costs associated with this change.

Alan estimates that Lionel must hire eight salespeople to cover the current market area, at an average annual payroll cost for each employee of $80,000, including fringe benefits expense. Travel and entertainment expenses is expected to total $740,000 for the year, and the annual cost of hiring a sales manager and sales secretary will be $220,000. In addition to their salaries, the eight salespeople will each earn commissions at the rate of 10% of sales. The president believes that Lionel also should increase its advertising budget by $640,000 if the eight salespeople are hired.

Required

1. Determine Lionel’s breakeven point (operating profit = 0) in sales dollars for the fiscal year ending June 30, 2019, if the company hires its own sales force and increases its advertising costs. Prove this by constructing a contribution income statement.

2. If Lionel continues to sell through its network of sales agents and pays the higher commission rate, determine the estimated volume in sales dollars that would be required to generate the operating profit as projected in the budgeted income statement.

Answer 1

Working as follows: Calculate contribution margin ratio as follows: Sales $29,900 Less: Cost of goods sold-variable Less: sales commission- variable (S29,900 x 10%) Contribution margin (S13,455) (S2,990) $13,455 Contribution margin ratio ($13455 + $29900) 45% Calculate Total fixed cost as follows: Fixed: Cost of goods sold Advertising cost (S897 + S640) Adminitrative cost Annual sales payroll cost (8 employee x $80) Travel & Entertainment expenses Sales manager & Secretary hiring cost Total $3,588 S1,537 $2,392 $640 $740 $220 $9,117

1. Compute breakeven point: Total Fixed Cost Breakeven sales in dollars=- Contribution margin ratio $9,117 45% $20, 260 2. Working as follows: Fixed Cost +Desiredoperating income Target Sales volumein doll ars= Contribution margin ratio Where, Contribution margin ratio = 1- variable cost ratio.

Compute variable cost ratio as follows: Variable cost of goods sold ratio ($13455/$29900) Variable sales commission ratio (23% of sales) Total variable cost ratio 0.45 0.23 0.68 Contribution margin ratio = 1– 0.68 = 0.32 Compute fixed cost as follows: Fixed: Cost of goods sold Advertising cost Administrative cost $3,588 $897 $2,392 Total $6,877 Compute desired operating income as follows:

Linonel Corp. Budgeted Income statement For the year Ending June 30, 2019 (S000 omitted) Sales (Computed in (1) above Variable costs: S20,260 COGS [($13455/S29900) × $20260] Sales commission ($20260 x 10%) Contribution margin Fixed cost: Current ($3588+$897+S2392) Incremental ($500+$640+$740+$220) (S9,117) ($11,143) $9,117 (S2,026) (S6,877) (S2,100) (S8,977) Operating Income $140

Fixed Cost +Desiredoperating income Contributi on margin ratio Target Sales volumein dollars= S6877+$140 0.32 $21928.13