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 $ 19,000,000 Manufacturing expenses: Variable $ 7,700,000 Fixed overhead 2,740,000 10,440,000 Gross margin 8,560,000 Selling and administrative expenses: Commissions to agents 3,040,000 Fixed marketing expenses 220,000* Fixed administrative expenses 2,300,000 5,560,000 Net operating income 3,000,000 Fixed interest expenses 640,000 Income before income taxes 2,360,000 Income taxes (30%) 708,000 Net income $ 1,652,000 *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 21%.” “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 21% 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 8.5% 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 $3,040,000 per year, but that would be more than offset by the $3,990,000 (21% × $19,000,000) that we would avoid on agents’ commissions.” The breakdown of the $3,040,000 cost follows: Salaries: Sales manager $ 200,000 Salespersons 1,100,000 Travel and entertainment 800,000 Advertising 940,000 Total $ 3,040,000 “Super,” replied Karl. “And I noticed that the $3,040,000 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 $125,000 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%. b. The agents’ commission rate is increased to 21%. c. The company employs its own sales force. 2. Assume that Pittman Company decides to continue selling through agents and pays the 21% 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.) 3. Determine the volume of sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 21% 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.) 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.) b. The agents’ commission rate is increased to 21%. (Round your answer to 2 decimal places.) c. The company employs its own sales force. (Round your answer to 2 decimal places.) References

Answer 1

The data in the statements below are in thousands.
	16% Commission		21% Commission		Own Sales Force
Sales	19,000	100	19,000	100	19,000	100
Variable expenses:
Manufacturing	7,700		7,700		7,700
Commissions (16%, 21%, 8.5%)	3,040		3,990		1,615
Total variable expenses	10,740	56.5%	11,690	61.5%	9,315	49.0%
Contribution margin	8,260	43.5%	7,310	38.5%	9,685	51.0%
Fixed expenses:
Manufacturing overhead	2,740		2,740		2,740
Marketing 3,040+220	220		220		3,260
Administrative 2300-125	2,300		2,300		2,175
Interest	640		640		640
Total fixed expenses	5,900		5,900		8,815
Income before income taxes	2,360		1,410		870
Income taxes (30%)	708		423		261
Net income	1,652		987		609

1(A)

Break-even point in dollar sales if the commission remains 16%

Dollar sales to break even = Fixed Expenses/CM ratio

5900000/.435

13563218

b

Break-even point in dollar sales if the commission remains 21%

5900000/.385

15324675.32

c

Break-even point in dollar sales if the company employs its own sales force:

8815000/.51

17,284,314

2

In order to generate a $1,652,000 net income, the company must generate $2,360,000 in income before taxes. Therefore

Dollar sales to attain target =Target income before taxes + Fixed expenses/CM ratio

(1652000+5900000)/0.385

19615584

3

X = Total sales revenue

0.615X + $5,900,000 = 0.49X + $8,815,000

0.125X = $2,915,000

23320000

4	16% Commission	21% Commission	Own Sales Force
Contribution margin	8,260	7,310	9,685
Income before taxes	2,360	1,410	870
Degree of operating leverage	3.50	5.18	11.13