Question

Klyne Corporation manufactures pharmaceutical products that are sold through a network of sales agents. The agents are paid a commission of 24% of sales. The income statement for the year ending December 31, 2017, is as follows:

KLYNE CORPORATION Income Statement For the Year Ending December 31, 2017
Sales			$	29,000,000
Cost of goods sold
Variable	$	14,790,000
Fixed		2,876,000		17,666,000
Gross margin				11,334,000
Selling and marketing expenses
Commissions		6,960,000
Fixed costs		3,270,000		10,230,000
Operating income			$	1,104,000

Klyne is considering hiring its own sales staff to replace the network of agents. Klyne will pay its salespeople a commission of 12% and incur fixed costs of $2,086,000.

Required:

1.	Calculate Klyne Corporation’s break-even point in sales dollars for the year 2017. (Round your answer to 2 decimal places.)

2.	Calculate Klyne Corporation’s break-even point in sales dollars for the year 2017 if the company had hired its own sales force to replace the network of agents. (Round your answer to 2 decimal places.)

3.	Calculate the degree of operating leverage at sales of $29,000,000, considering (a) Klyne uses sales agents and (b) Klyne employs its own staff. Describe the advantages and disadvantages of each alternative. (Round your answers to 2 decimal places.)

4.	If Klyne increases the commission paid to its sales staff to 10%, keeping all other costs the same, how much revenue (in dollars) would Klyne have to generate to earn the same operating income it did in 2017? (Round your answer to 2 decimal places.)

Answer 1

	Using sales agent		Using own sales force
Revenue		29000000		29000000
Variable costs
Cost of goods sold - variable	14790000		14790000
Marketing commissions	6960000 (29000000*24%)	21750000	3480000 (29000000*12%)	18270000
Contribution margin		7250000		10730000
Fixed costs
Cost of goods sold - fixed	2876000		2876000
Marketing - fixed	3270000	6146000	5356000 (3270000+2086000)	8232000
Operating income		1104000		2498000
Contribution margin ratio (contribution margin /revenue)		25% (7250000/29000000)		37% (10730000/29000000)

Part 1

Breakeven point dollar sales = fixed costs/contribution margin ratio = 6146000/25% = 24584000

Part 2

Breakeven point in dollar sales = fixed costs / contribution margin ratio = 8232000/29% = 28386206.90

Part 3 (a)

Degree of operating leverage = contribution margin / operating income = 7250000/1104000 = 6.57

Part 3 (b)

Degree of operating leverage = contribution margin / operating income = 10730000/2498000 = 4.30

Advantages and disadvantages :

Thecalculations indicate that at sales of $29,000,000, a percentage change in sales and contribution margin will result in 6.57 times that percentage change in operating income if Klyne continues to use sales agents and 4.30 times that percentage change in operatingincome if Kline employs its own sales staff. The higher contribution margin per dollar ofsales and higher fixed costs fails to give Kyle more operating leverage, that is, greater benefits(increases in operating income) if revenues increase but greater risks (decreases in operatingincome) if revenues decrease. Kline also needs to consider the skill levels and incentives under the two alternatives. Sales agents have more incentive compensation and, hence, may bemore motivated to increase sales. On the other hand, Klyne’s own sales force may be more knowledgeable and skilled in selling the company’s products. That is, the sales volume itself willbe affected by who sells and by the nature of the compensation plan.

Part 4

Operating income = R - variable manufacturing costs - fixed manufacturing costs - variable marketing costs - fixed marketing costs

2498000 = R-0.51R-2876000-0.22R-5356000

0.27R = 10730000

R = 39740740.70