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				$	16,000,000
Manufacturing expenses:
Variable	$	7,200,000
Fixed overhead		2,340,000			9,540,000
Gross margin					6,460,000
Selling and administrative expenses:
Commissions to agents		2,400,000
Fixed marketing expenses		120,000	*
Fixed administrative expenses		1,800,000			4,320,000
Net operating income					2,140,000
Fixed interest expenses					540,000
Income before income taxes					1,600,000
Income taxes (30%)					480,000
Net income				$	1,120,000

*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’ 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 $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% × $16,000,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,400,000 cost follows:

Salaries:
Sales manager	$	100,000
Salespersons		600,000
Travel and entertainment		400,000
Advertising		1,300,000
Total	$	2,400,000

“Super,” replied Karl. “And I noticed that the $2,400,000 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 $75,000 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

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Data Given in Question
Pittman Company
Particulars	Amount $	Amount $
Sales		16,000,000.00
Manufacturing Exp.
Variable	7,200,000.00
Fixed	2,340,000.00	9,540,000.00
Gross Margin		6,460,000.00
Selling & Administrative Exp.
Commission to agents	2,400,000.00
Fixed marketing expenses	120,000.00
Fixed administrative expenses	1,800,000.00	4,320,000.00
Net Operating Income		2,140,000.00
Fixed Interest Exp.		540,000.00
Income before tax		1,600,000.00
Income tax (30%)		480,000.00
Net Income		1,120,000.00

	Income Statement
	Particulars	Amount $
	Sales	16,000,000.00	A
Less	Commission to agents	2,400,000.00	B
	Net Sales (net of commission)	13,600,000.00	C
Less	Variable Manufacturing Exp.	7,200,000.00	D
	Contribution	6,400,000.00	E
Less	Fixed costs
	Fixed Manufacturing Exp.	2,340,000.00	F
	Fixed marketing expenses	120,000.00	G
	Fixed administrative expenses	1,800,000.00	H
	Fixed Interest Exp.	540,000.00	I
	Income before tax	1,600,000.00	J
Less	Income tax (30%)	480,000.00	K
	Net Income	1,120,000.00	L
	Variable cost to % of sales	45.00%	M= D/A
	Contribution to % of sales	40.00%	N=E/A

Calculation of fixed cost if commission is 15%
Particulars	Amount $
Fixed Manufacturing Exp.	2,340,000.00
Fixed marketing expenses	120,000.00
Fixed administrative expenses	1,800,000.00
Fixed Interest Exp.	540,000.00
Total Fixed cost	4,800,000.00	O

We know at Break even point Contribution is equal to fixed cost and profit is zero.
So contribution needed for breakeven business is $ 4,800,000.
Contribution to % of net sales	40.00%	N
So net sales will be contribution/Contribution to % of net sales:
Break-even Sales	12,000,000.00	P=O/N

Proof
Break-even Sales	12,000,000.00
Commission at 15%	1,800,000.00
Variable Manufacturing Exp.	5,400,000.00
Contribution	4,800,000.00
Total Fixed cost	4,800,000.00
Net Income	-
Ans to 1 a	12,000,000.00

Calculation of fixed cost if commission is 20%
Particulars	Amount $
Fixed Manufacturing Exp.	2,340,000.00
Fixed marketing expenses	120,000.00
Fixed administrative expenses	1,800,000.00
Fixed Interest Exp.	540,000.00
Total Fixed cost	4,800,000.00	O

We know at Break even point Contribution is equal to fixed cost and profit is zero.
So contribution needed for breakeven business is $ 4,800,000.
Now here commission increased by 5% so contribution
will decrease by 5% as commission has direct impact on contribution.
Contribution to % of net sales	35.00%	N
Break-even Sales	13,714,285.71	P=O/N

Proof
Break-even Sales	13,714,285.71
Commission at 20%	2,742,857.14
Variable Manufacturing Exp.	6,171,428.57
Contribution	4,800,000.00
Total Fixed cost	4,800,000.00
Net Income	-
Ans to 1 b	13,714,285.71

Calculation of fixed cost if own sales force
Particulars	Amount $
Fixed Manufacturing Exp.	2,340,000.00
Fixed marketing expenses	120,000.00
Fixed administrative expenses	1,800,000.00
Fixed Interest Exp.	540,000.00
Cost of own sales force	2,400,000.00
Less: Savings in auditor's fees	75,000.00
Total Fixed cost	7,125,000.00	Q

We know at Break even point Contribution is equal to fixed cost and profit is zero.
Now here commission is 7.50% so contribution
will increase by 7.50% as commission has direct impact on contribution.
So contribution needed for breakeven business is $ 7,125,000.
Contribution to % of net sales	47.50%	N
So net sales will be contribution/Contribution to % of net sales:
Break-even Sales	15,000,000.00	R=Q/N

Proof
Break-even Sales	15,000,000.00
Commission	1,125,000.00
Variable Manufacturing Exp.	6,750,000.00
Contribution	7,125,000.00
Total Fixed cost	7,125,000.00
Net Income	-
Ans to 1 c	15,000,000.00

	Ans to Q-2
	If the commission rate is 20% and we need the same net income level then we will do back calculation to arrive at the figures
	Net Income Required	1,120,000.00
Add	Income tax (30%)	480,000.00
	Income before tax	1,600,000.00
Add	Fixed costs
	Fixed Manufacturing Exp.	2,340,000.00
	Fixed marketing expenses	120,000.00
	Fixed administrative expenses	1,800,000.00
	Fixed Interest Exp.	540,000.00
	Contribution required	6,400,000.00	T
	So contribution needed is $ 6,400,000
	Contribution to % of net sales	35.00%	N
	Break-even Sales	18,285,714.29	S=T/N
	Proof
	Break-even Sales	18,285,714.29
	Commission at 20%	3,657,142.86
	Variable Manufacturing Exp.	8,228,571.43
	Contribution	6,400,000.00
	Total Fixed cost	4,800,000.00
	Income before tax	1,600,000.00
	Income tax (30%)	480,000.00
	Net Income	1,120,000.00