Question

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				$	25,000,000
Manufacturing expenses:
Variable	$	11,250,000
Fixed overhead		3,500,000			14,750,000
Gross margin					10,250,000
Selling and administrative expenses:
Commissions to agents		3,750,000
Fixed marketing expenses		175,000	*
Fixed administrative expenses		2,160,000			6,085,000
Net operating income					4,165,000
Fixed interest expenses					875,000
Income before income taxes					3,290,000
Income taxes (30%)					987,000
Net income				$	2,303,000

*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 $3,750,000 per year, but that would be more than offset by the $5,000,000 (20% × $25,000,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,750,000 cost follows:

Salaries:
Sales manager	$	156,250
Salespersons		937,500
Travel and entertainment		625,000
Advertising		2,031,250
Total	$	3,750,000

“Super,” replied Karl. “And I noticed that the $3,750,000 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 $115,000 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

Ans. 1

Pittman Company’s break-even point in dollar sales for next year assuming:

	15% Commission	20% Commission	Own sales force
Sales	25,000,000	25,000,000	25,000,000
Variable expenses:
Manufacturing	11,250,000	11,250,000	11,250,000
Commissions (15%, 20%, 7.5%)	3,750,000	5,000,000	1,875,000
Total variable expenses	15,000,000	16,250,000	13,125,000
Contribution margin	10,000,000	8,750,000	11,875,000
Variable expenses ratio	60%	65%	52.5%
Contribution margin ratio	40%	35%	47.5%
Fixed expenses:
Manufacturing overhead	3,500,000	3,500,000	3,500,000
Marketing	175,000	175,000	3,925,000
Administrative	2,160,000	2,160,000	2,045,000
Interest	875,000	875,000	875,000
Total fixed expenses	6,710,000	6,710,000	10,345,000
Income before income taxes	3,290,000	2,040,000	1,530,000
Income taxes (30%)	987,000	612,000	459,000
Net income	2,303,000	1,428,000	1,071,000
Break even point in dollars	16,775,000	19,171,429	21,778,947

Working Notes:-

1. Fixed marketing expenses -own sales force

Fixed marketing expenses	175,000
Add:- Amount paid as commission	3,750,000
Total Fixed marketing expenses	3,925,000

2. Fixed administrative expenses-own sales force

Fixed administrative expenses	2,160,000
Less:- Cost savings	115,000
Total Fixed administrative expenses	2,045,000

3. Break even point=(Total fixed expenses / Contribution margin ratio)

15% Commission	(6,710,000/40%)=16,775,000
20% Commission	(6,710,000/35%)=19,171,429
Own sales force	(10,345,000/47.5%)=21,778,947

Ans. 2

Pittman Company decides to continue selling through agents and pays the 20% commission rate.

Sales required to generate the same net income
Income before tax as per income statement	3,290,000
Total fixed expenses	6,710,000
Total	10,000,000
Contribution margin ratio	35%
Sales required to generate the same net income	28,571,429

Sales required to generate the same net income=(Total fixed expenses / Contribution margin ratio)

Sales required to generate the same net income=(10,000,000 / 35%)=28,571,429

Ans. 3

Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force.

Let sales volume be "S"

S=Total sale volume

(100% - 35%) x S + Fixed cost=(100% - 47.5%) x S + Fixed cost

65% x S + 6,710,000=52.50% x S+ 10,575,000

65% x S - 52.50% x S=10,575,000 - 6,710,000

12.5% x S=3,865,000

S=3,865,000/12.5%

S=30,920,000

Hence, total sales volume is 30,920,000.

Ans. 4

Compute the degree of operating leverage that the company would expect to have at the end of next year assuming:

	15% Commission	20% commission	own sales force
Contribution margin	10,000,000	8,750,000	11,875,000
Income before income taxes	3,290,000	2,040,000	1,530,000
Degree of operating leverage	3.04	4.29	7.76

Working Notes:-

Degree of operating leverage=(Contribution margin / Income before income taxes)

15% Commission	(10,000,000/8,750,000)=3.04
20% Commission	(8,750,000/2,040,000)=4.29
Own sales force	(11,875,000/1,530,000)=7.76