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.

Answer 1

Solution 1:
	15% commission	20% commission	own sales force
Sales	16000000	16000000	16000000
Variable expenses:
Manufacturing	7200000	7200000	7200000
Commission	2400000	3200000	1200000
Total variable expenses	9600000	10400000	8400000
Contribution margin	6400000	5600000	7600000
Variable expenses ratio	60.00%	65.00%	52.50%
Contribution margin ratio	40.000%	35.000%	47.500%
Fixed expenses:
Manufacturing overhead	2340000	2340000	2340000
Marketing	120000	120000	2520000
Administrative	1800000	1800000	1725000
Interest	540000	540000	540000
Total fixed expenses	4800000	4800000	7125000
Income before income taxes	1600000	800000	475000
Income taxes(30%)	480000	240000	142500
Net income	1120000	560000	332500
Break Even Point in dollars (Total Fixed Expenses/Controbution margin ratio)	12000000	13714286	15000000

Solution 2:
Income before tax as per income statement	1600000
Total Fixed Expenses (when 20% commission)	4800000
Total	6400000
/ Contribution margin ratio (When 20% commission)	35.000%
Sales required to generate target profit	18285714

Solution 3:

Let Sales Volume be "X"

Total Cost when commission 20% = Total Cost for Own sales Force

0.6500*X +4800000 = 0.5250*X +7125000

0.125*X = 2325000

X = 232500/0.125

X = 18600000

Hence, Sales volume required is $18,600,000.