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 19% for all items sold.

Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year. The statement follows:

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales			$	17,200,000
Manufacturing expenses:
Variable	$	7,400,000
Fixed overhead		2,500,000		9,900,000
Gross margin				7,300,000
Selling and administrative expenses:
Commissions to agents		3,268,000
Fixed marketing expenses		160,000*
Fixed administrative expenses		2,000,000		5,428,000
Net operating income				1,872,000
Fixed interest expenses				580,000
Income before income taxes				1,292,000
Income taxes (25%)				323,000
Net income			$	969,000

*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’ 19% 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 24%.”

“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 24% 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 6.0% 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 $3,268,000 per year, but that would be more than offset by the $4,128,000 (24% × $17,200,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,268,000 cost follows:

   

Salaries:
Sales manager	$	140,000
Salespersons		800,000
Travel and entertainment		560,000
Advertising		1,768,000
Total	$	3,268,000

“Super,” replied Karl. “And I noticed that the $3,268,000 is just what we’re paying the agents under the old 19% commission rate.”

“It’s even better than that,” explained Barbara. “We can actually save $145,000 a year because that’s what we’re having to pay the auditing firm now 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: (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places and final answers to the nearest dollar amount.)

  

a. The agents’ commission rate remains unchanged at 19%.

    

b. The agents’ commission rate is increased to 24%.

   

c. The company employs its own sales force.

2. Assume that Pittman Company decides to continue selling through agents and pays the 24% commission rate. Determine the volume of sales that would be required to generate the same net income as contained in the budgeted income statement for next year. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)

   

3. Determine the volume of sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 24% commission rate) or employs its own sales force. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)

4. Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming:

  

a. The agents’ commission rate remains unchanged at 19%. (Round your answer to 2 decimal places.)

b. The agents’ commission rate is increased to 24%. (Round your answer to 2 decimal places.)

c. The company employs its own sales force. (Round your answer to 2 decimal places.)

Answer 1

	Pittman Company
Working Notes
					a=19% commission	b=24% commission	Own sales force
	Sales				17200000	17200000	17200000
	Less : Variable cost
	Variable Manufacturing expenses				7400000	7400000	7400000
	Variable selling expenses(Commission)				3268000	4128000	0
	Total Variable expense				10668000	11528000	7400000
		Contribution Margin			6532000	5672000	9800000
		Margin Ratio			37.98	32.98	56.98
	Fixed cost
	Manufacturing overhead				2500000	2500000	2500000
	Selling expenses				160000	160000	160000
	Administrative expenses				2000000	2000000	1855000
		Total fixed cost			4660000	4660000	4515000
Requirement 1	Break even sales in dollar
	=Total fixed cost/Margin ratio				12270667	14131171	7924286
Requirement 2	Assuming increased commission of 24% and same operating profit as budgeted
						b=24% commission
	Sales					17200000
	Less : Variable cost
	Variable Manufacturing expenses					7400000
	Variable selling expenses(Commission)					4128000
	Total Variable expense					11528000
		Contribution Margin				5672000
		Margin Ratio				32.98	%
	Fixed cost
	Manufacturing overhead					2500000
	Selling expenses					160000
	Administrative expenses					2000000
		Total fixed cost				4660000
	To get the same Net operating Income we need to work out revised contribution
			Net Operating Income			1872000
			Add : Fixed expenses			4660000
			Total contirbution required			6532000
	Required sales are			=	=6532000/32.98%
					19807898.45
Requirement 3	Indifference point at which dollar sales is equal between alternative of 24% commission
	and employing own sales force
					24% commission	Own sales force	Difference
	Fixed costs				4660000	4515000	145000
	Margin ratio				32.98	56.98	24.00
	Required sales are			=	=145000/24%
				=	11625000
Requirement 4	Computation of operating leverage
	Operating Leverage=		contribution margin/Income before taxes
					a=19% commission	b=24% commission	Own sales force
	Sales				17200000	17200000	17200000
	Less : Variable cost
	Variable Manufacturing expenses				7400000	7400000	7400000
	Variable selling expenses(Commission)				3268000	4128000	0
	Total Variable expense				10668000	11528000	7400000
		Contribution Margin		A	6532000	5672000	9800000
	Fixed cost
	Manufacturing overhead				2500000	2500000	2500000
	Selling expenses				160000	160000	160000
	Administrative expenses				2000000	2000000	1855000
		Total fixed cost			4660000	4660000	4515000
		Operating profit			1872000	1012000	5285000
	Less : Fixed Interest expenses				580000	580000	580000
		Income before taxes		B	1292000	432000	4705000
	Operating Leverage		=	A/B	5.06	13.13	2.08