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 17% 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

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales			$	16,600,000
Manufacturing expenses:
Variable	$	7,300,000
Fixed overhead		2,420,000		9,720,000
Gross margin				6,880,000
Selling and administrative expenses:
Commissions to agents		2,822,000
Fixed marketing expenses		140,000*
Fixed administrative expenses		1,900,000		4,862,000
Net operating income				2,018,000
Fixed interest expenses				560,000
Income before income taxes				1,458,000
Income taxes (40%)				583,200
Net income			$	874,800

*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’ 17% 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 22%.” “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 22% 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 7.7% 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 $2,822,000 per year, but that would be more than offset by the $3,652,000 (22% × $16,600,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,822,000 cost follows:

Salaries:
Sales manager	$	120,000
Salespersons		700,000
Travel and entertainment		480,000
Advertising		1,522,000
Total	$	2,822,000

“Super,” replied Karl. “And I noticed that the $2,822,000 is just what we’re paying the agents under the old 17% commission rate.” “It’s even better than that,” explained Barbara. “We can actually save $85,000 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 17%.

b. The agents’ commission rate is increased to 22%.

c. The company employs its own sales force.

2. Assume that Pittman Company decides to continue selling through agents and pays the 22% 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 22% 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 17%. (Round your answer to 2 decimal places.)

b. The agents’ commission rate is increased to 22%. (Round your answer to 2 decimal places.)

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

Answer 1

		Budgeted income statement for different alternatives:
				17% commission		22% commission		Own sales force
	Sales (a)			16600000	100%	16600000	100%	16600000	100%
	Variable expenses:
	Manufacturing			7300000		7300000		7300000
	Commissions			2822000		3652000		1278200
						(16600000*22%)		(16600000*7.7%)
	Total variable expenses (b)			10122000	60.98%	10952000	65.98%	8578200	51.68%
	Contribution margin ©=(a)-(b)			6478000	39.02%	5648000	34.02%	8021800	48.32%
	Fixed expenses:
	Manufacturing overhead			2420000		2420000		2420000
	Marketing			140000		140000		2962000	*
								(140000+2822000)
	Administrative			1900000		1900000		1815000	**
								(1900000-85000)
	Interest			560000		560000		560000
	Total fixed expenses (d)			5020000		5020000		7757000
	Income before income taxes €=©-(d)			1458000		628000		264800
	Less: Taxes @ 40%			583200		251200		105920
	Net income			874800		376800		158880
	* Additional fixed expense of $2822000 added in Marketing expenses
	** Savings in audit fees reduced from administrative cost
1	Breakeven point in $=Fixed expenses/Contribution margin %
a.	Breakeven point in $=5020000/39.02%=$ 12865197
b.	Breakeven point in $=5020000/34.02%=$ 14756026
c.	Breakeven point in $=7757000/48.32%=$ 16053394
2	Required net income before taxes=$ 874800
	Sales required to attain the target=(Required net income before taxes+Fixed expenses)/Contribution margin %=(874800+5020000)/39.02%=$ 15107125
3	We need to make the net income equal under both alternatives.Hence.Total expenses under both alternatives would be same
	Assume x=Total sales revenue
	Total expenses under 20 % commission=0.6598x+5020000
	Total expenses under own sales force=0.5168x+7757000
	0.6598x+5020000=0.5168x+7757000
	(0.6598-0.5168)x=7125000-4800000
	0.143x=2325000
	x=2325000/0.125=$ 16258741
4	Degree of operating leverage=Contribution margin/Income before taxes
a.	Degree of operating leverage=6478000/1458000=4.44
b.	Degree of operating leverage=5648000/628000=8.99
c.	Degree of operating leverage=8021800/264800=16