Question

XYZ Company is located in California and 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.

Lisa, XYZ’s controller, has just prepared the company’s budgeted income statement for next year as follows:

XYZ 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 Lisa handed the statement to Jason Smith, XYZ’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,” Jason 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 Lisa.

“I say it’s just plain robbery,” retorted Jason. “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 Lisa. “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 Jason. “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 Lisa. “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 Jason. “With the approval of the committee, we can move on the matter immediately.”

Required:

Maximum 3 pages for your answers as follow:

Page 1 and 2 for answering the Requirement 1-5 and Page 3 for answering the Requirement 6.

Show the detailed computation for part 1-4.

1. Compute XYZ 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 XYZ 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 XYZ 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.

5.Based on the data in (1) through (4), make recommendations to weather the company should continue to use the sales agent (at a 20% commission rate) or employ its own sales force. Give reasons for your answer.

Answer 1

		Budgeted income statement for different alternatives:
				15% commission		20% commission		Own sales force
	Sales (a)			16000000	100%	16000000	100%	16000000	100%
	Variable expenses:
	Manufacturing			7200000		7200000		7200000
	Commissions			2400000		3200000		1200000
						(16000000*20%)		(16000000*7.5%)
	Total variable expenses (b)			9600000	60.00%	10400000	65.00%	8400000	52.50%
	Contribution margin ©=(a)-(b)			6400000	40.00%	5600000	35.00%	7600000	47.50%
	Fixed expenses:
	Manufacturing overhead			2340000		2340000		2340000
	Marketing			120000		120000		2520000	*
								(120000+2400000)
	Administrative			1800000		1800000		1725000	**
								(1800000-75000)
	Interest			540000		540000		540000
	Total fixed expenses (d)			4800000		4800000		7125000
	Income before income taxes €=©-(d)			1600000		800000		475000
	Less: Taxes @ 30%			480000		240000		142500
	Net income			1120000		560000		332500
	* Additional fixed expense of $2400000 added in Marketing expenses
	** Savings in audit fees reduced from administrative cost
1	Breakeven point in $=Fixed expenses/Contribution margin %
a.	Breakeven point in $=4800000/40%=$ 12000000
b.	Breakeven point in $=4800000/35%=$ 13714286
c.	Breakeven point in $=7125000/47.50%=$ 15000000
2	Required net income before taxes=$ 1120000
	Sales required to attain the target=(Required net income before taxes+Fixed expenses)/Contribution margin %=(1120000+4800000)/40%=$ 14800000
3	We need to make the net income equal under both alternatives.Hence.Total expenses under both alternatives would be same
	Assume x=Total sales revenue
	Total expenses under 20 % commission=0.65x+4800000
	Total expenses under own sales force=0.525x+7125000
	0.65x+4800000=0.525x+7125000
	(0.65-0.525)x=7125000-4800000
	x=2325000/0.125=$ 18600000
4	Degree of operating leverage=Contribution margin/Income before taxes
a.	Degree of operating leverage=6400000/1600000=4
b.	Degree of operating leverage=5600000/800000=7
c.	Degree of operating leverage=7600000/475000=16
5	Based on Net income,It is better to go with 20% commission Since net income of 20% commission ($560000) which is more than net income Under Own sales force ($332500)