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

Solution 1:
	15% commission	20% commission	own sales force
Sales	22500000	22500000	22500000
Variable expenses:
Manufacturing	10125000	10125000	10125000
Commission	3375000	4500000	1687500
Total variable expenses	13500000	14625000	11812500
Contribution margin	9000000	7875000	10687500
Variable expenses ratio	60.00%	65.00%	52.50%
Contribution margin ratio	40.000%	35.000%	47.500%
Fixed expenses:
Manufacturing overhead	3150000	3150000	3150000
Marketing	157500	157500	3532500
Administrative	2060000	2060000	1956500
Interest	787500	787500	787500
Total fixed expenses	6155000	6155000	9426500
Income before income taxes	2845000	1720000	1261000
Income taxes(30%)	853500	516000	378300
Net income	1991500	1204000	882700
Break Even Point in dollars (Total Fixed Expenses/Controbution margin ratio)	15387500	17585714	19845263

Solution 2:
Income before tax as per income statement	2845000
Total Fixed Expenses (when 20% commission)	6155000
Total	9000000
/ Contribution margin ratio (When 20% commission)	35.000%
Sales required to generate target profit	25714286

Solution 3:

Let Sales Volume be "X"

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

0.6500*X +6155000 = 0.5250*X +9426500

0.125*X = 3271500

X = 3271500/0.125

X = 26172000

Hence, Sales volume required is $26,172,000.

Solution 4:
	15% commission	20% commission	own sales force
Contribution margin	9000000	7875000	10687500
Income before taxes	2845000	1720000	1261000
Degree of Operating Leverage (Contribution margin/Income before taxes)	3.16	4.58	8.48