Question

"PITTMAN COMPANY" CMA ADAPTED 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. The statement follows: $16,000,000 9.540,000 6,460,000 Pittman Company Budgeted Income Statement For the Year Ended December 31, 2018 Sales Manufacturing cost: Variable overhead $7,200,000 Fixed overhead 2,340,000 Gross Margin Selling and administrative expenses: Commissions to agents 2,400,000 Fixed marketing expenses 120,000* Fixed administrative expenses 1,800,000 Net Operating Income Fixed interest expenses Income before income taxes Income tax (30%) Net income *Primarily depreciation on storage facilities 4.320.000 2,140,000 540,000 1,600,000 480,000 $1,120,000 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

Answer 1

(The data in the statements below are in thousands.)

		15% Commission		20% Commission		Own Sales Force
Sales..............................................................		$16,000	100%		$16,000	100%		$16,000.00		100.0%
Variable expenses:
Manufacturing...........................................		7,200			7,200			7,200.00
Commissions (15%, 20% 7.5%)................		2,400			3,200			1,200.00
Total variable expenses..................................		9,600	60%		10,400	65%		8,400.00		52.5%
Contribution margin......................................		6,400	40%		5,600	35%		7,600.00		47.5%
Fixed expenses:
Manufacturing overhead...........................		2,340			2,340			2,340.00
Marketing..................................................		120			120			2,520.00	*
Administrative...........................................		1,800			1,800			1,725.00	**
Interest.......................................................		540			540			540.00
Total fixed expenses......................................		4,800			4,800			7,125.00
Income before income taxes..........................		1,600			800			475.00
Income taxes (30%).......................................		480			240			142.50
Net income....................................................		$ 1,120			$ 560			$ 332.50

*$120,000 + $2,400,000 = $2,520,000

**$1,800,000 – $75,000 = $1,725,000

1.   When the income before taxes is zero, income taxes will also be zero and net income will be zero. Therefore, the break-even calculations can be based on the income before taxes.

      a.   Break-even point in dollar sales if the commission remains 15%:

Dollar sales to break even Fixed expenses CM ratio $4,800,000 0.40 = $12,000,000

  b.   Break-even point in dollar sales if the commission increases to 20%:

Dollar sales to break even = Fixed expenses CM ratio $4,800,000 0.35 = $13,714,286

c. Break-even point in dollar sales if the company employs its own sales force:

Dollar sales to break even Fixed expenses CM ratio $7,125,000 0.475 $15,000,000

2.   In order to generate a $1,120,000 net income, the company must generate $1,600,000 in income before taxes. Therefore,

Dollar sales to attain target Target income before taxes + Fixed expenses CM ratio $1,600,000 + $4,800,000 0.35 II $6,400,000 0.35 $18,285,714

3.         To determine the volume of sales at which net income would be equal under either the 20% commission plan or the company sales force plan, we find the volume of sales where costs before income taxes under the two plans are equal. See the next page for the solution.

	X =	Total sales revenue
	0.65X + $4,800,000 =	0.525X + $7,125,000
	0.125X =	$2,325,000
	X =	$2,325,000 ÷ 0.125
	X =	$18,600,000

      Thus, at a sales level of $18,600,000 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.

4.   a., b., and c.

	15% Commission	20% Commission	Own Sales Force
Contribution margin (Part 1) (a)......................	$6,400,000	$5,600,000	$7,600,000
Income before taxes (Part 1) (b).....................	$1,600,000	$800,000	$475,000
Degree of operating leverage: (a) ÷ (b)........................................................	4	7	16

5.         We would continue to use the sales agents for at least one more year, and possibly for two more years. The reasons are as follows:

            First, use of the sales agents would have a less dramatic effect on net income.

            Second, use of the sales agents for at least one more year would give the company more time to hire competent people and get the sales group organized.

            Third, the sales force plan doesn’t become more desirable than the use of sales agents until the company reaches sales of $18,600,000 a year. This level probably won’t be reached for at least one more year, and possibly two years.

            Fourth, the sales force plan will be highly leveraged since it will     increase fixed costs (and decrease variable costs). One or two years from now, when sales have reached the $18,600,000 level, the company can benefit greatly from this leverage. For the moment, profits will be greater and risks will be less by staying with the agents, even at the higher 20% commission rate.