Question

9-43 CVP Analysis; Commissions; Ethics 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) $28,500 Sales Cost goods sold Variable $12,825 3.500 Fixed 16,325 Gross profit $12.175 Selling and administrative costs $ 5.130 Commissions Fixed advertising cost 800 Fixed administrative cost 2.150 8,080 Operating income $ 4,095 Fixed interest cost 705 Income before income taxes $3,390 Income taxes (30%) 1.017 Net income $2,373 their commission rate (to 23%) for the upcoming year. As a result, Lionel's president has decided to investigate Since the completion of the income statement, Lionel has learned that its sales agents are requiring a 5 % increase 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, expected to total $600,000 for the year, and the annual cost of hiring a sales manager and sales secretary will be $150,000. In addition to their salaries, the eight salespeople will cach carn commissions at the rate of 10 % of sales. The president believes that Lionel also should increase its advertising budget by $500,000 if the eight salespeople are hired. $80,000, including fringe benefits expense. Travel and entertainment expenses is an average annual payroll cost for each employee Required 1. Determine Lionel's breakeven point statement. sales dollars for the fiscal year ending June 30, 2019, the company hires its own sales force and increases its advertising costs. Prove this by constructing a contribution income page 349 sales dollars that would be required to generate the operating profit as projected. 2. If Lionel continues in the budgeted income statement. sell through its network of sales agents and pays the higher commission rate, determine the estimated volume 3. Describe the general assumptions underlying breakeven analysis that may limit its usefulness. sales for the firm to either accept the agents' demand 4. What is the indifference point r adopt the proposed change? Which plan is better for the firm? Why? 5. What are the ethical issues, if any, that Alan should consider?

Answer 1

Requirement 1 in $'000s Contribution Income Statement in $'000s Selling price p.u (-) Variable expenses Variable COGS Variable Sales Commission (28500*10%) Total Variable expenses Contribution Margin |(-) Fixed Expenses Fixed COGS Fixed Sales Salaries (80000*8) Fixed Advertising costs (800+500) Travel and entertainment expenses Cost of hiring sales manager Fixed Administrative Costs Total Fixed expenses Operating Income |(-) Fixed interest cost Income before Income taxes |(-) Income taxes (30%) Net Income 28,500 12,825 2,850 15,675 12,825 3,500 640 1,300 600 150 2,150 8,340 4,485 -705 3,780 -1,134 2,646 Computation of Break even Point Contribution margin in $ 000's 12,825 Sales 28,500 45% (12825/28500) Contribution margin ratio Total Fixed operating expenses 8,340 Contribution Margin ratio 45% Break-even point (in Sales $) (Fixed Expenses/Contribution margin ratio) 18,533 (8340/45%)

Requirement 2 in $'000s Existing Budgeted Sales () Existing Budgeted Variable COGS 28500 -12825 () Existing Budgeted Variable commissions Existing Budgeted Contribution Existing Contribution margin ratio -5130 10545 37% When sales commission increases by 5%, the contribution shall reduce by 5% Hence. Revised Contribution margin ratio (37-5) 32% Required Contribution Required Sales Volume (10545/32%) 10545 32953.125 Requirement 3 General Assumptions underlying Break-even Analysis 1) Total costs can be easily classified into Fixed and variable catagories. 2) Selling price per unit, remains constant irrespective of quantities of units sold 3) productivity or Efficiency of factors of production remain same. 4) All resources are abundantly available. 5) Both revenue and cost functions are linear.

Requirement 4 Indiffence Point (in sales $) = Difference in Fixed costs Change in Contribution margin ratio Option 1 (network of sales agents) Option 2 (own sales staff) Total Fixed expense $ 6,450 $ 8,340 Total Fixed expense (3500+800+2150) (as computed in Req 1) Contribution margin ratio 32% Contribution margin ratio 45% (12825/28500) (as computed in Req 2) Hence, Indifference Point = (8340-6450) (45%-32%) Hence, Indifference Point = $14,538 Since, sales of the company lies above the indiffence point, option with higher contribution margin ratio is most profitable. Hence, the plan for hiring its own sales staff is better since it is having higher contribution margin ratio than the other option.