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:

$ 18,500,000 10,915,000 7,585,000 Pittman Company Budgeted Income Statement For the Year Ended December 31 Sales Manufacturing expenses: Variable $ 8,325,000 Fixed overhead 2,590,000 Gross margin Selling and administrative expenses: Commissions to agents 2,775,000 Fixed marketing expenses 129,500* Fixed administrative expenses 1,900,000 Net operating income Fixed interest expenses Income before income taxes Income taxes (30%) Net income 4,804,500 2,780,500 647,500 2,133,000 639,900 $ 1,493,100

*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 $2,775,000 per year, but that would be more than offset by the $3,700,000 (20% × $18,500,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,775,000 cost follows:

Answer 1

Q 1 Computation of breakeven point
Particulars		Commisssion	Own Sales
	20%	25%
Sales	A	1,85,00,000	1,85,00,000	1,85,00,000
Variable expenses:
Manufacturing	B	83,25,000	83,25,000	83,25,000
Commissions (15%, 20%, 7.5%)	C	27,75,000	37,00,000	13,87,500
Total variable expenses	D=B+C	1,11,00,000	1,20,25,000	97,12,500
Contribution margin	E=A-D	74,00,000	64,75,000	87,87,500
Contribution = Contribution/Sales*100	F=E/A	40.00	35.00	47.50
Fixed expenses:
Manufacturing overhead		25,90,000	25,90,000	25,90,000
Marketing		1,29,500	1,29,500	29,04,500
Administrative		19,00,000	19,00,000	18,14,900
Interest		6,47,500	6,47,500	6,47,500
Total fixed expenses	G	52,67,000	52,67,000	79,56,900
Income before income taxes	H=E-G	21,33,000	12,08,000	8,30,600
Income taxes (30%)	I=H*30%	6,39,900	3,62,400	2,49,180
Net income	J=H-I	14,93,100	8,45,600	5,81,420
Breakeven point Fixed cost/Contribution Ratio	K	1,31,67,500	1,50,48,571	1,67,51,368
		5267000/.4	5267000/.35	7956900/.475
Answer To Question No. 2
Sales=(Target income before taxes + Fixed expenses)/Contribution ratio
Sales	(2133000+5267000)/0.35	2,11,42,857
Answer to Question No. 3
0.65Total sales volume+52,67,000=0.525 Total sales volume+79,56,900
0.65-0.525=79,56,900-52,67,000		2,15,19,200
Answer to Question No. 4
		Commisssion	Own Sales
		20%	25%
Contrubution Margin		74,00,000	64,75,000	87,87,500
Income before taxes		21,33,000	12,08,000	8,30,600
Degree of operating leverage		3.47	5.36	10.58