Question

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)
Sales				$	28,500
Cost of goods sold
Variable	$	12,825
Fixed		3,500			16,325
Gross profit				$	12,175
Selling and administrative costs
Commissions	$	5,130
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

Since the completion of the income statement, Lionel has learned that its sales agents are requiring a 5% increase in their commission rate (to 23%) for the upcoming year. As a result, Lionel’s president has decided to investigate 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, at an average annual payroll cost for each employee of $80,000, including fringe benefits expense. Travel and entertainment expenses is 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 each earn 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.

Required

-Determine Lionel’s breakeven point (operating profit = 0) in sales dollars for the fiscal year ending June 30, 2019, if the company hires its own sales force and increases its advertising costs. Prove this by constructing a contribution income statement.

-If Lionel continues to sell through its network of sales agents and pays the higher commission rate, determine the estimated volume in sales dollars that would be required to generate the operating profit as projected in the budgeted income statement.

-Describe the general assumptions underlying breakeven analysis that may limit its usefulness.

-What is the indifference point in sales for the firm to either accept the agents' demand or adopt the proposed change? Determine which plan is better for the firm.

-Are there ethical issues?

Answer 1

• Determination of Breakeven Point:

The breakeven point (BEP) is that quantity of output sold at which total revenues equal total cots- that is , the qunatity of output sold at which the opearting income is $0.

Step 1: Calculation of Contribution Margin Percentage

Sales	28,500,000
Variable Expenses:
Cost of goods sold	12,825,000
Selling Commission (10%)	2,850,000
Contribution Margin	12,825,000
Contribution Margin Percentage (Contribution Margin/Sales)	45%

Step 2: Calculation of Total Fixed Costs

Fixed Cost of Goods Sold	3,500,000
Fixed Advertising Cost                           ($800,000 + Increase of $500,000)	1,300,000
Fixed Administrative Cost	2,150,000
Fixed Payroll Cost of 8 Salespeople ($80,000 x 8)	640,000
Fixed Travel and Entertainment Expenses	600,000
Fixed Cost of Hiring a Sales Manager and Sales Secretary	150,000
Fixed Interest Cost	705,000
	9,045,000

Step 3: Calculation of Breakeven Point

Breakeven Sales	20,100,000
Variable Expenses:
Cost of goods sold (45%)	9,045,000
Selling Commission	2,010,000
Contribution Margin	9,045,000
Fixed Expenses:
Fixed Cost of Goods Sold	3,500,000
Fixed Advertising Cost	1,300,000
Fixed Administrative Cost	2,150,000
Fixed Payroll Cost of 8 Salespeople	640,000
Fixed Travel and Entertainment Expenses	600,000
Fixed Cost of Hiring a Sales Manager and Sales Secretary	150,000
Fixed Interest Cost	705,000
Total Fixed Expenses	9,045,000
Operating Income	0

• Estimation of Sales Revenue to earn the Budgeted Profit

Step 1: Calculation of Contribution Margin Percentage

Sales	28,500,000
Variable Expenses:
Cost of goods sold (45%)	12,825,000
Selling Commission (23%)	6,555,000
Contribution Margin	9,120,000
Contribution Margin Percentage (Contribution Margin/Sales)	32%

Step 2: Target Operating Income = $3,390,000

Step 3: Calculation of Total Fixed Costs

Fixed Cost of Goods Sold	3,500,000
Fixed Advertising Cost	800,000
Fixed Administrative Cost	2,150,000
Fixed Interest Cost	705,000
	7,155,000

Step 4: Computation of Estimated Sales Revenue to earn Target Operating Income

Estimated Sales	32,953,125
Variable Expenses:
Cost of goods sold (45%)	14,828,906
Selling Commission (23%)	7,579,219
Contribution Margin	10,545,000
Fixed Expenses:
Fixed Cost of Goods Sold	3,500,000
Fixed Advertising Cost	800,000
Fixed Administrative Cost	2,150,000
Fixed Interest Cost	705,000
Total Fixed Expenses	7,155,000
Operating Income	3,390,000
Income taxes (30%)	1,017,000
Net income	2,373,000

• Indifference Point between two alternatives

It is quantity or revenue at which opearting Income between two alternatives will be equals that both alternatives will be indifferent to each other.

Let's assume the the indifference point sales will be x.

Therefore the Indifference Point Sales will be $14,538,461

Note:

A1 = Alternative 1

A2 = Alternative 2

Alternative 1
Breakeven Sales	14,538,461
Variable Expenses:
Cost of goods sold (45%)	6,542,307
Selling Commission	1,453,846
Contribution Margin	6,542,307
Fixed Expenses:
Fixed Cost of Goods Sold	3,500,000
Fixed Advertising Cost	1,300,000
Fixed Administrative Cost	2,150,000
Fixed Payroll Cost of 8 Salespeople	640,000
Fixed Travel and Entertainment Expenses	600,000
Fixed Cost of Hiring a Sales Manager and Sales Secretary	150,000
Fixed Interest Cost	705,000
Total Fixed Expenses	9,045,000
Operating Income	(2,502,693)

	Alternative 2
Estimated Sales	14,538,461
Variable Expenses:
Cost of goods sold (45%)	6,542,307
Selling Commission (23%)	3,343,846
Contribution Margin	4,652,308
Fixed Expenses:
Fixed Cost of Goods Sold	3,500,000
Fixed Advertising Cost	800,000
Fixed Administrative Cost	2,150,000
Fixed Interest Cost	705,000
Total Fixed Expenses	7,155,000
Operating Income	(2,502,692)