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 $ 22,000,000 Manufacturing expenses: Variable $ 9,900,000 Fixed overhead 3,080,000 12,980,000 Gross margin 9,020,000 Selling and administrative expenses: Commissions to agents 3,300,000 Fixed marketing expenses 154,000 * Fixed administrative expenses 2,040,000 5,494,000 Net operating income 3,526,000 Fixed interest expenses 770,000 Income before income taxes 2,756,000 Income taxes (30%) 826,800 Net income $ 1,929,200 *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 $3,300,000 per year, but that would be more than offset by the $4,400,000 (20% × $22,000,000) that we would avoid on agents’ commissions.” The breakdown of the $3,300,000 cost follows: Salaries: Sales manager $ 137,500 Salespersons 825,000 Travel and entertainment 550,000 Advertising 1,787,500 Total $ 3,300,000 “Super,” replied Karl. “And I noticed that the $3,300,000 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 $101,200 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

Solution 1:
	15% commission	20% commission	own sales force
Sales	22000000	22000000	22000000
Variable expenses:
Manufacturing	9900000	9900000	9900000
Commission	3300000	4400000	1650000
Total variable expenses	13200000	14300000	11550000
Contribution margin	8800000	7700000	10450000
Variable expenses ratio	60.00%	65.00%	52.50%
Contribution margin ratio	40.000%	35.000%	47.500%
Fixed expenses:
Manufacturing overhead	3080000	3080000	3080000
Marketing	154000	154000	3454000
Administrative	2040000	2040000	1938800
Interest	770000	770000	770000
Total fixed expenses	6044000	6044000	9242800
Income before income taxes	2756000	1656000	1207200
Income taxes(30%)	826800	496800	362160
Net income	1929200	1159200	845040
Break Even Point in dollars (Total Fixed Expenses/Controbution margin ratio)	15110000	17268571	19458526

Solution 2:
Income before tax as per income statement	2756000
Total Fixed Expenses (when 20% commission)	6044000
Total	8800000
/ Contribution margin ratio (When 20% commission)	35.000%
Sales required to generate target profit	25142857

Solution 3:

Let Sales Volume be "X"

Total Cost when commission 20% = Total Cost for Own sales Force

0.6500*X +6044000 = 0.5250*X +9242800

0.125*X = 3198800

X = 3198800/0.125

X = 25590400

Hence, Sales volume required is $25,590,400.

Solution 4:
	15% commission	20% commission	own sales force
Contribution margin	8800000	7700000	10450000
Income before taxes	2756000	1656000	1207200
Degree of Operating Leverage (Contribution margin/Income before taxes)	3.19	4.65	8.66