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: Pittman Company Budgeted Income Statement For the Year Ended December 31 Sales $ 22,000,000 Manufacturing expenses: Variable $ 9,900,000 Fixed overhead 3,080,000 12,980,000 Gross margin 9,020,000 Selling and administrative expenses: Commissions to agents 3,300,000 Fixed marketing expenses 154,000 * Fixed administrative expenses 2,040,000 5,494,000 Net operating income 3,526,000 Fixed interest expenses 770,000 Income before income taxes 2,756,000 Income taxes (30%) 826,800 Net income $ 1,929,200 *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 $3,300,000 per year, but that would be more than offset by the $4,400,000 (20% × $22,000,000) that we would avoid on agents’ commissions.” The breakdown of the $3,300,000 cost follows: Salaries: Sales manager $ 137,500 Salespersons 825,000 Travel and entertainment 550,000 Advertising 1,787,500 Total $ 3,300,000 “Super,” replied Karl. “And I noticed that the $3,300,000 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 $101,200 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

Budgeted income statement for next year

i)When sales commission to the commission agents is 15% and 20%

Particulars	When commission is 15% (Amount in $)	When commission is 20% (Amount in $)
Sales	22,000,000	22,000,000
Less: Variable expenses:
Manufacturing expenses	9,900,000	9,900,000
Sales Commission	3,300,000	4,400,000
Total variable expenses	13,200,000	14,300,000
Contribution	8,800,000	7,700,000
Contribution margin ratio	0.40	0.35
Less: Fixed expenses
Fixed overhead	3,080,000	3,080,000
Fixed marketing expenses	154,000	154,000
Fixed administration expenses	2,040,000	2,040,000
Fixed interest expense	770,000	770,000
Total fixed expenses	6,044,000	6,044,000
Profit before tax	2,756,000	1,656,000
Less: Tax @30%	826,800	496,800
Net income	1,929,200	1,159,200

ii) When inhouse salesforce is been appointed ( no sales commission)

Particulars	When there is no commission (Amount in $)
Sales	22,000,000
Less: Variable expenses:
Manufacturing expenses	9,900,000
Sales Commission (Assumed sales commission of 7.5% is not applicable)	NIL
Total variable expenses	9,900,000
Contribution	12,100,000
Contribution margin ratio	0.55
Less: Fixed expenses
Fixed overhead	3,080,000
Fixed marketing expenses	154,000
Fixed expense due to the inhouse sales team	3,300,000
Fixed administration expenses	1,938,800
Fixed interest expense	770,000
Total fixed expenses	9,242,800
Profit before tax	2,857,200
Less: Tax @30%	857,160
Net income	2,000,040

Answer 1) Computation of Break-Even Point (BEP) in dollar sales for the next year

BEP in dollars = Total fixed cost / Contribution margin ratio

Contribution margin ratio = Contribution / Sales

a) When the sales commission is 15%

BEP = 6,044,000 / 40% = $15,110,000

b) When sales commission is 20%

BEP = 6,044,000 / 35% = $17,268,571

c) When inhouse sales team is appointed

BEP = 9,242,800 / 55% = $16,805,090

2)

Desired income when sales commission is 20% = $1,929,200

Sales required to achieve the desired income

Therefore, Sales required to earn a profit of $1,929,000, with asales commission of 20% = $22,780,571.

3) Let X be the total sales revenue,

0.65X + 6,044,000 = 0.45X + 9,242,800

0.20X = 3,198,800 = X = 15,994,000.

4)

	@Sales commission 15%	@Sales commission 20%	Inhouse sales team
a)Contribution margin	8,800,000	7,700,000	12,100,000
b)Profit before tax	2,756,000	1,656,000	2,857,200
Degree of operating leverage (a / b)	3.193	4.65	4.235