Question

Lionel Corporation manufactures pharmaceutical products sold through a network of sales agents in the United States and Canada. The agents are currently paid an 18% commission on sales; that percentage was used when Lionel prepared the following budgeted income statement for the fiscal year ending June 30, 2019:

Lionel Corporation
Budgeted Income Statement
For the Year Ending June 30, 2019
($000 omitted)
Sales				$	30,200
Cost of goods sold
Variable	$	13,590
Fixed		3,624			17,214
Gross profit				$	12,986
Selling and administrative costs
Commissions	$	5,436
Fixed advertising cost		906
Fixed administrative cost		2,416			8,758
Operating income				$	4,228
Fixed interest cost					755
Income before income taxes				$	3,473
Income taxes (30%)					1,042
Net income				$	2,431

Since the completion of the income statement, Lionel has learned that its sales agents are requiring a 5% increase in their commission rate (to 23%) for the upcoming year. As a result, Lionel’s president has decided to investigate the possibility of hiring its own sales staff in place of the network of sales agents and has asked Alan Chen, Lionel’s controller, to gather information on the costs associated with this change.

Alan estimates that Lionel must hire eight salespeople to cover the current market area, at an average annual payroll cost for each employee of $80,000, including fringe benefits expense. Travel and entertainment expenses is expected to total $770,000 for the year, and the annual cost of hiring a sales manager and sales secretary will be $235,000. In addition to their salaries, the eight salespeople will each earn commissions at the rate of 10% of sales. The president believes that Lionel also should increase its advertising budget by $670,000 if the eight salespeople are hired.

Required

1. Determine Lionel’s breakeven point (operating profit = 0) in sales dollars for the fiscal year ending June 30, 2019, if the company hires its own sales force and increases its advertising costs. Prove this by constructing a contribution income statement.

2. If Lionel continues to sell through its network of sales agents and pays the higher commission rate, determine the estimated volume in sales dollars that would be required to generate the operating profit as projected in the budgeted income statement.

Answer 1

Solution

Solution

Lionel Corporation

1. Determination of break-even point in sales dollars for the fiscal year ending June 30, 2019, assuming the company hires its own sales force and increases its advertising costs:

a.             Own sales force:

Break-even point in sales dollars = fixed cost/CM ratio

Fixed cost = fixed cost of goods sold + fixed administrative costs + fixed advertising costs + fixed selling costs

Fixed advertising costs = 906,000 + 670,000 = $1,576,000

Additional cost of hiring own sales force = travel and entertainment cost + salesmen salaries + sales staff

= $770,000 + $640,000 +$235,000 = $1,645,000

            = $3,624,000 + $2,416,000 + $1,576,000 +$1,645,000 = $9,261,000

CM ratio or contribution margin ratio = (contribution margin/sales) x 100

Contribution margin = sales – variable costs

Sales                                                                           $30,200,000

Variable costs –

Cost of goods sold                              $13,590,000

Selling and marketing expenses,

Commissions (10% of 30,200,000)    $3,020,000    

Total variable costs                            $16,610,000

Contribution margin                           $13,590,000

CM ratio                                             (13,590,000/ $30,200,000) x 100

CM ratio = 45%

Break-even point in dollar sales = fixed cost/CM ratio

                                                = total fixed cost/ CM ratio

            = $9,261,000/45% = $20,580,000

Hence, the break-even point in sales dollars increases when the company opts to employ its own sales force instead of hiring from the market.

2. Determination of estimated volume in sales dollars that is needed to generate the operating profit assuming the company sells through its own network of sales agents and pays higher commission rate –

Current sales $30,200,000

Variable cost:

COGS              $13,590,000

Commission    $5,436,000

Total variable cost $19,026,000

Contribution margin $11,174,000

CM ratio = 37%

If sales commission increases by 5%, the CM ratio decreases by 5%. The revised CM ratio = 32%

Desired contribution margin to maintain current level of operating income = $11,174,000

Desired sales volume = 11,174,000/32% = $34,918,750