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 $ 19,500,000 Manufacturing expenses: Variable $ 8,775,000 Fixed overhead 2,730,000 11,505,000 Gross margin 7,995,000 Selling and administrative expenses: Commissions to agents 2,925,000 Fixed marketing expenses 136,500 * Fixed administrative expenses 1,940,000 5,001,500 Net operating income 2,993,500 Fixed interest expenses 682,500 Income before income taxes 2,311,000 Income taxes (30%) 693,300 Net income $ 1,617,700 *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 $2,925,000 per year, but that would be more than offset by the $3,900,000 (20% × $19,500,000) that we would avoid on agents’ commissions.” The breakdown of the $2,925,000 cost follows: Salaries: Sales manager $ 121,875 Salespersons 731,250 Travel and entertainment 487,500 Advertising 1,584,375 Total $ 2,925,000 “Super,” replied Karl. “And I noticed that the $2,925,000 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 $89,700 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.” Required: 1. Compute Pittman Company’s break-even point in dollar sales for next year assuming: a. The agents’ commission rate remains unchanged at 15%. b. The agents’ commission rate is increased to 20%. c. The company employs its own sales force. 2. Assume that Pittman Company decides to continue selling through agents and pays the 20% commission rate. Determine the dollar sales that would be required to generate the same net income as contained in the budgeted income statement for next year. 3. Determine the dollar sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force. 4. Compute the degree of operating leverage that the company would expect to have at the end of next year assuming: a. The agents’ commission rate remains unchanged at 15%. b. The agents’ commission rate is increased to 20%. c. The company employs its own sales force. Use income before income taxes in your operating leverage computation.

Answer 1

The data in the statements below are in thousands.

	15% Commission						20% Commission						Own Sales Force
Sales	$	19500		100	%		$	19500		100	%		$	19500		100.0	%
Variable expenses:
Manufacturing		8775						8775						8775
Commissions (15%, 20%, 7.5%)		2925						3900						1462.50
Total variable expenses		11700		60.0	%			12675		65.0	%			10237.50		52.5	%
Contribution margin		7800		40.0	%			6825		35.0	%			9262.50		47.5	%
Fixed expenses:
Manufacturing overhead		2730						2730						2730
Marketing		136.50						136.50						3061.5
Administrative		1940						1940						1850.30
Interest		682.50						682.50						682.50
Total fixed expenses		5489.00						5489.00						8324.30
Income before income taxes		2311.00						1336.00						938.20
Income taxes (30%)		693.30						400.80						281.46
Net income	$	1617.70					$	935.20					$	656.74

136500+2925000 = 3061500 1940000-89700 = 1850300

Part 1 A

Dollar sales to break even= fixed expenses/CM ratio = 5489000/0.400 = 13722500

Part 1 B

Dollar sales to break even= fixed expenses/CM ratio = 5489000/0.350 = 15682857

Part 1 C

Dollar sales to break even= fixed expenses/CM ratio = 8324300/0.475 = 17524842

Part 2

In order to generate a $1617700 net income, the company must generate $2311000 in income before taxes

Dollar sales to attain target= target income before taxes + fixed expenses / contribution margin ratio = (2311000+5489000)/ 0.350 = $22285714

Part 3

X = total sales revenue

0.650x+5489000 = 0.525x+8324300

0.125x =2745300

X = 21962400

Part 4

	15% Commission	20% Commission	Own Sales Force
Contribution margin (Part 1) (a)	7800000	6825000	9262500
Income before taxes (Part 1) (b)	2311000	1336000	932800
Degree of operating leverage: (a) ÷ (b)	3.38	5.11	9.93

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