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

Solution:

Exisiting contribution margin = Sales - Variable cost = $29,000,000 - ($14,790,000 + $6,960,000) = $7,250,000

Contribution margin ratio = $7,250,000 / $29,000,000 = 25%

Fixed costs = $2,876,000 + $3,270,000 = $6,146,000

Breakeven point in sales dollars = Fixed cost / contribution margin ratio = $6,146,000 / 25% = $24,584,000

Solution 2:

New contribution margin for 2017 = $29,000,000 - ($14,790,000 + $29,000,000*12%) = $10,730,000

New contribution margin ratio = $10,730,000 / $29,000,000 = 37%

New Fixed costs = $6,146,000 + $2,086,000 = $8,232,000

New break even point in sales dollar = $8,232,000 / 37% = $22,248,664.86

Solution 3:

Operating leverage if Klyne uses sales agents:

Operating income = $1,104,000

Contribution margin = $7,250,000

Operating leverage = Contribution / Net operating income = $7,250,000 / $1,104,000 = 6.57

Operating leverage if Klyne employs its own staff:

Operating income = $10,730,000 - $8,232,000 = $2,498,000

Conribution margin = $10,730,000

Operating leverage = $10,730,000 / $2,498,000 = 4.30

Advantage and disvantage of sales agent alternative:

In this alternative, all commissions paid to sales agent are variable with sales, if agent make more sales they will earn more commission. commission rate is also high i.e. 24% of sales. The main advantage is this method of commission encourge agent to do more sale to earn sales commission. As sale is more than company will earn more operating income. Fruther this alternative is having high degree of operating leverage, it means after breakeven, operating income will increase at a very high speed.

The disadvantge of this method is that its breakeven point is very high due to low contribution margin ratio. Company is to acheive high level of sale in order to breakevent.

Advantage and disadvantage of sales staff alternative:

The adavantage of this method is, in this method variable cost is at lower side, resulting in high contribution margin ratio, but fixed costs are high as compared to sales agent alternative.

Solution 4:

Revised contributon margin = $29,000,000 - ($14,790,000 + $29,000,000*10%) = $11,310,000

New contribution margin ratio = $11,310,000 / $29,000,000 = 39%

Desired operating income = $1,104,000

Fixed costs = $8,232,000

Desired contribution margin = $1,104,000 + $8,232,000 = $9,336,000

Revenue required to earn same operating income = Desired contributiom margin / contribution margin ratio

= $9,336,000 / 39% = $23,938,461.54