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 16% for all items sold.

Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year. The statement follows:

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales			$	20,800,000
Manufacturing expenses:
Variable	$	8,000,000
Fixed overhead		2,980,000		10,980,000
Gross margin				9,820,000
Selling and administrative expenses:
Commissions to agents		3,328,000
Fixed marketing expenses		280,000*
Fixed administrative expenses		2,600,000		6,208,000
Net operating income				3,612,000
Fixed interest expenses				700,000
Income before income taxes				2,912,000
Income taxes (35%)				1,019,200
Net income			$	1,892,800

*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’ 16% 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 18%.”

“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 18% 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 8.0% 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 $3,328,000 per year, but that would be more than offset by the $3,744,000 (18% × $20,800,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,328,000 cost follows:

   

Salaries:
Sales manager	$	260,000
Salespersons		1,400,000
Travel and entertainment		1,040,000
Advertising		628,000
Total	$	3,328,000

“Super,” replied Karl. “And I noticed that the $3,328,000 is just what we’re paying the agents under the old 16% commission rate.”

“It’s even better than that,” explained Barbara. “We can actually save $155,000 a year because that’s what we’re having to pay the auditing firm now 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.”

Required:

1. Compute Pittman Company’s break-even point in dollar sales for next year assuming: (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places and final answers to the nearest dollar amount.)

  

a. The agents’ commission rate remains unchanged at 16%.

break-even point in dollar sales:

    

b. The agents’ commission rate is increased to 18%.

break-even point in dollar sales:

   

c. The company employs its own sales force.

break-even point in dollar sales:

2. Assume that Pittman Company decides to continue selling through agents and pays the 18% commission rate. Determine the volume of sales that would be required to generate the same net income as contained in the budgeted income statement for next year. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)

volume of sales (in dollars):

   

3. Determine the volume of sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 18% commission rate) or employs its own sales force. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)

volume of sales (in dollars):

4. Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming:

  

a. The agents’ commission rate remains unchanged at 16%. (Round your answer to 2 decimal places.)

degree of operating leverage:

b. The agents’ commission rate is increased to 18%. (Round your answer to 2 decimal places.)

degree of operating leverage:

c. The company employs its own sales force. (Round your answer to 2 decimal places.)

degree of operating leverage:

Answer 1

1). Calculation of breakeven point:
a). When agent commission rate is at 16%:
Total Fixed cost = 2,980,000+280,000+2,600,000+700,000 = 6,560,000
Contribution required for breakeven = 6,560,000
Contribution as per budgeted = 20,800,000 - 8,000,000 - 3,328,000 = 9,472,000
% of contribution = 9,472,000 / 20,800,000 = 45.54% approx
Breakeven sales = 6,560,000 / 45.54% = $14,404,919 approx

b). Agents commission rate is 18%
New Contribution as per budgeted = 20,800,000 - 8,000,000 - 3,744,000(18% of sales) = $9,056,000
% of contribution = 9,056,000 / 20,800,000 = 43.54%
Contribution required for breakeven = 6,560,000
Breakeven sales = 6,560,000 / 43.54% = $ 15,066,605.42

c). Company Employs its own sales force:
Sales                                     20,800,000
Less: Variable mfr cost             8,000,000
Contribution                            12,800,000
Less Fixed Cost
       Salaries to sales staff       3,328,000
       Overhead                         2.980,000
       Marketing                          280,000
       Administrative                   2,445,000
       Interest Expense                700,000
Profit                                       3,067,000

Contribution % = 61.54%
Total fixed costs = 3,328,000 + 2980000 + 280000+2445000 + 700000 = 9,733,000
Breakeven sales = 9733000 / 61.45% = $15,838,893.41

2). Profit before taxes as per budgeted = $2,912,000
Contribution margin % = 43.54% if sales commission at 18%
Contribution required = Total fixed costs + Budgeted profit = 6,560,000 + 2,912,000 = $9,472,000
Sales = 9,472,000 / 43.54% = $21,754,708.31

3). Sales at which net income at own sales force and at 18% commission is equal :
Let sales be x:
Net profit at 18% commission = 0.4354x - 6,560,000
Net profit at own sales force = 0.6154x - 3,328,000 - 6,405,000 = 0.6154x - 9,733,000
Equating both the equations:
0.4354x - 6,560,000 = 0.6154x - 9,733,000
0.18x = 3173000
x = $17,627,777.77 i.e sales

4). Operating Leverage = Contribution / EBIT
a) If commission at 16% = 9,472,000 / 2912000 = 3.25
b). If commission at 18% = 9,056,000 / 2496000 = 3.63
c). IF own sales force = 12,800,000 / 3,067,000 = 4.17