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

Answer 1

a.	Break-even point in dollar sales						12,000,000
	BEP(dollar sales) =		fixed expense/contribution margin ratio
			Fixed cost				4,800,000
			Contribution margin				40.0%
b)	Break even point in dollar sales						13,714,286
c)	Break even point in dollar sales						15,000,000
2)	Voulme of sales (in dollars)						18,285,714
	(Target income before taxes +fixed expense)/contribution margin
3)	Voulme of Sales (in dollars)						18,600,000
	X =	total evenue
	.65 X + 4,800,000=		.525x +7,125,000
		0.125	x	=		2,325,000
			x =	18600000
4)
a)	Degree of operating leverage						4.00
b)	Degree of operating leverage						7.00
c)	Degree of operating leverage						16.00
	degree of operating leverage = contribution marging/income before taxes

Working notes

			15% comm		20% comm		7.5% comm
Sales			16,000,000	100%	16,000,000	100%	16,000,000	100%
Variable expenses:
manufacturing			7,200,000		7,200,000		7,200,000
comissions (15%;20%,7.5%)			2,400,000		3200000		1200000
total variable expense			9,600,000	60.0%	10,400,000	65.0%	8,400,000	52.5%
contribution margin			6,400,000	40.0%	5,600,000	35.0%	7,600,000	47.5%
fixed expenses
manufacturing overhead			2,340,000		2,340,000		2,340,000
marketing			120,000		120,000		2,520,000
administrative			1,800,000		1,800,000		1,725,000
interest			540,000		540,000		540,000
total fixed expense			4,800,000		4,800,000		7,125,000
income before income taxes			1,600,000		800,000		475,000
income taxes (30%)			480000		240000		142500
net income			1,120,000		560,000		332,500
increase in fixed expense-marketing							2,400,000
saving in administrative expense							-75000