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 $ 22,500,000 Manufacturing expenses: Variable $ 10,125,000 Fixed overhead 3,150,000 13,275,000 Gross margin 9,225,000 Selling and administrative expenses: Commissions to agents 3,375,000 Fixed marketing expenses 157,500 * Fixed administrative expenses 2,060,000 5,592,500 Net operating income 3,632,500 Fixed interest expenses 787,500 Income before income taxes 2,845,000 Income taxes (30%) 853,500 Net income $ 1,991,500 *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 $3,375,000 per year, but that would be more than offset by the $4,500,000 (20% × $22,500,000) that we would avoid on agents’ commissions.” The breakdown of the $3,375,000 cost follows: Salaries: Sales manager $ 140,625 Salespersons 843,750 Travel and entertainment 562,500 Advertising 1,828,125 Total $ 3,375,000 “Super,” replied Karl. “And I noticed that the $3,375,000 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 $103,500 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. 4. Compute the degree of operating leverage that the company would expect to have at the end of 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. Use income before income taxes in your operating leverage computation.

Answer 1

	Before proceeding with the solution, it is helpful first to restructure the data into contribution format for each of the three alternatives. (The data in the statements below are in thousands.)
		15%Commission		20% Commission		Own Sales Force -7.5%
	Sales	$22,500	100%	$22,500	100%	$22,500.00	100.00%
	Variable expenses:
	Manufacturing	10,125		10,125		10,125.00
	Commissions (15%, 20%, 7.5%)	3,375		4,500		1,687.50
	Total variable expenses	13,500	60.0%	14,625	65.0%	11,812.50	52.5%
	Contribution margin	9,000	40.0%	7,875	35.0%	10,687.5	47.5%
	Fixed expenses:
	Manufacturing overhead	3,150		3,150		3,150.00
	Marketing	157.5		157.5		3,532.5 *
	Administrative	2,060		2,060		1,956.5 **
	Interest	787.5		787.5		787.5
	Total fixed expenses	6,155		6,155		9,426.50
	Income before income taxes	2,845		1,720		1,261.0
	Income taxes (30%)	853.5		516		378.3
	Net income	$1,991.50		$1,204.00		$882.70
	*$157,500 + $3,375,000 = $3,532,500
	**$2,060,000 - $103,500 = $1,956,500
1	When the income before taxes is zero, income taxes will also be zero and net income will be zero. Therefore, the break-even calculations can be based on the income before taxes.
a	Break-even point in dollar sales if the commission remains 15%:
	Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$6,155,000 ÷ 0.400 =		$15,387,500
b	Break-even point in dollar sales if the commission increases to 20%:
	Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$6,155,000 ÷ 0.350 =		$17,585,714
c	Break-even point in dollar sales if the company employs its own sales force:
	Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$9,426,500 ÷ 0.475 =		$19,845,263
2	In order to generate a $1,991,500 net income, the company must generate $2,845,000 in income before taxes. Therefore,
	Dollar sales to attain target =	(Target income before taxes + Fixed expenses) ÷ CM ratio
		($2,845,000+$6,155,000) ÷ 0.350
		$9,000,000 ÷ 0.350 =		$25,714,286
3	To determine the volume of sales at which net income would be equal under either the 20% commission plan or the company sales force plan, we find the volume of sales where costs before income taxes under the two plans are equal. See below
	X = Total sales revenue
	0.650X + $6,155,000 = 0.525X + $9,426,500
	0.125X = $3,271,500
	X = $3,271,500 ÷ 0.125
	X = $26,172,000
	Thus, at a sales level of $26,172,000 either plan would yield the same income before taxes and net income. Below this sales level, the commission plan would yield the largest net income; above this sales level, the sales force plan would yield the largest net income.
4	a., b., and c.
		15% Commission		20% Commission		Own Sales Force
	Contribution margin (Part 1) (x)	$                       9,000,000		$                                7,875,000		$         10,687,500
	Income before taxes (Part 1) (y)	$                       2,845,000		$                                1,720,000		$           1,261,000
	Degree of operating leverage: (X) ÷ (Y)	3.16		4.58		8.48