Question

Outback Outfitters is a manufacturer of recreational equipment. It has been experiencing an average growth rate of 20% in sales over the past 5 years. It is August 31 and the financial controller has just prepared the company’s budgeted income statement for next year. The company has no sales force of its own and outsourcing its selling and marketing functions to an independent sales agents. The commission paid to the agent is 12% on sales for all the different products the company sold. The statement follows:（answer question d，e，f and g）

Outback Outfitters
Budgeted Income Statement
For the Year Ended December 31 (in thousand dollars)
Sales		$100,000
Manufacturing expenses:
Variable	$40,000
Fixed overhead	20,000	60,000
Gross margin		40,000
Selling and administrative expenses:
Commissions to agents	12,000
Fixed marketing expenses	1,000
Fixed administrative expenses	12,000	25,000
Net operating income		$15,000

When the financial controller handed the statement to the CEO, the CEO informed the controller that the sales agent demanded an increase in the commission rate to 16% next year to cover the increasing expenses in marketing and selling the products of Outback Outfitters.

The CEO concerns that the sales agent might ask for further increase in the commission rate in the future and would like to set up its own sales team. He asks the help of the financial controller and he gathers the following information for setting up the sales team:

Commission rate to own sales team 8%

Annual salaries paid to sales manager	$    600,000
Annual salaries paid to salespersons	3,600,000
Travel and entertainment	2,400,000
Advertising	4,000,000
Total additional fixed expenses	$10,600,000

Required:

a. Prepare a contribution margin income statement for next year at the 16% commission rate.

b. Calculate the contribution margin ratio and break-even in dollar sales for next year assuming:

(1) Commission rate remains at 12%.

(2) Commission rate is increased to 16%.

c. Determine the volume of sales under 16% commission rate that would be required to generate the same net operating income under the 12% commission rate. Compute the margin of safety percentage under 16% commission rate.

d. Calculate the contribution margin ratio, break-even dollar sales and margin of safety if the company employs its own sales team.

e. Determine the volume of sales at which the net operating income would be equal regardless of whether the company sells through agents at 16% commission rate or employs its own sales team.

f. What is meant by the term operating leverage? Calculate the degree of operating leverage that the company would expect to have for next year assuming the company (1) sells through agents at 16% commission rate and (2) employs its own sales team.

g. Based on the data in (a) through (f) above, make a recommendation as to whether the company should continue to use sales agent (at 16% commission rate) or employ its own sales team. Give reasons for your answer.

Answer 1

Solutions:

Contribution Margin Income Statement - Sales Agents
Sales		100000000
Less: Variable Expenses
Manfacturing	40000000
Commissions to agents @ 16%	16000000	56000000
Contribution Margin		44000000
Less: Fixed Expenses
Overhead	20000000
Marketing Expenses	1000000
Administrative Expenses	12000000	33000000
Net Income		11000000
Contribution Margin Income Statement - Own Sales Team
Sales		100000000
Less: Variable Expenses
Manfacturing	40000000
Commissions to agents @ 8%	8000000	48000000
Contribution Margin		52000000
Less: Fixed Expenses
Overhead	20000000
Marketing Expenses	11600000
Administrative Expenses	12000000	43600000
Net Income		8400000

d.

CM Ratio
= Contribution Margin / Selling Price
52%
Break Even Point (Sales)
=Fixed Cost / CM Ratio
=43600000/52%
$83,846,154
Margin of Safety = Total Sales - BEP Sales
Sales	$100,000,000
BEP Sales	$83,846,154
Margin of Safety	$16,153,846

e.

	Agents	Own Team
Contribution Margin Ratio
Sales	100000000	100000000
Contribution Margin	44000000	52000000
Contribution Margin Ratio	44.00%	52.00%
Total Fixed Cost	33000000	43600000
Net Profit	(Sales*CM Ratio) - Fixed Costs	(Sales*CM Ratio) - Fixed Costs
	(Sales*48%)-33000000	(Sales*52%)-43600000
Here we want to equate both the above, as we the same profit at the same volume of sales
(Sales*48%)-33000000	=	(Sales*52%)-43600000
(Sales*52%)-(Sales*48%)	=	43600000-33000000
4%*Sales	=	10600000
Sales	=	10600000/4%
Sales	=	$26,50,00,000.00

f.

Degree of operating leverage helps one to know how efficiently a company uses its fixed costs to generate revenue. The higher the leverage, the more profit you can reap. In other words, if the DOL is low indicates that the company's variable costa are more than the fixed costs and any increase in sale will not lead to a significant increase in profits. At the same time, the risk the company is exposed to to cover the fixed cost is lesser.

Degree of Operating Leverage
= Contribution Margin / Operating Income
	Agents	Own Team
Contribution Margin	44000000	52000000
Operating Income	11000000	8400000
DOL	4.00	6.19

g.

In the given scenario, where the sales is in the increasing trend year after year, the company can opt for the its own sales team, as it wil be beneficial in the long term. The DOL is higher for having its own team, meaning lesser variable costs and more profits when the sales is going to increase.

The downside of continuing with the agents services, right now the company is gaining with the current sales, but its will not put the compny in an advantageous position when the sales are going to increase. Increase in sales will increase the variable cost therby reducing profits.