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. The statement follows:

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales			$	18,700,000
Manufacturing expenses:
Variable	$	7,650,000
Fixed overhead		2,700,000		10,350,000
Gross margin				8,350,000
Selling and administrative expenses:
Commissions to agents		2,805,000
Fixed marketing expenses		210,000*
Fixed administrative expenses		2,250,000		5,265,000
Net operating income				3,085,000
Fixed interest expenses				630,000
Income before income taxes				2,455,000
Income taxes (25%)				613,750
Net income			$	1,841,250

*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 8.4% 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 $2,805,000 per year, but that would be more than offset by the $3,740,000 (20% × $18,700,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,805,000 cost follows:

   

Salaries:
Sales manager	$	190,000
Salespersons		1,050,000
Travel and entertainment		760,000
Advertising		805,000
Total	$	2,805,000

“Super,” replied Karl. “And I noticed that the $2,805,000 is just what we’re paying the agents under the old 15% commission rate.”

“It’s even better than that,” explained Barbara. “We can actually save $120,000 a year because that’s what we’re having to pay the auditing firm now 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: (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places and final answers to the nearest dollar amount.)

  

a. The agents’ commission rate remains unchanged at 15%.

Breakeven point in dollar sales:

    

b. The agents’ commission rate is increased to 20%.

Breakeven point in dollar sales:

   

c. The company employs its own sales force.

Breakeven point in dollar sales:

2. Assume that Pittman Company decides to continue selling through agents and pays the 20% commission rate. Determine the volume of sales that would be required to generate the same net income as contained in the budgeted income statement for next year. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)

volume of sales (in dollars):

   

3. Determine the volume of 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. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)

volume of sales (in dollars):

4. Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming:

  

a. The agents’ commission rate remains unchanged at 15%. (Round your answer to 2 decimal places.)

degree of operating leverage:

b. The agents’ commission rate is increased to 20%. (Round your answer to 2 decimal places.)

degree of operating leverage:

c. The company employs its own sales force. (Round your answer to 2 decimal places.)

degree of operating leverage:

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 -8.4%
	Sales	$18,700	100%	$18,700	100%	$18,700.00	100.00%
	Variable expenses:
	Manufacturing	7,650		7,650		7,650.00
	Commissions (15%, 20%, 8.4%)	2,805		3,740		1,570.80
	Total variable expenses	10,455	55.9%	11,390	60.9%	9,220.80	49.3%
	Contribution margin	8,245	44.1%	7,310	39.1%	9,479.2	50.7%
	Fixed expenses:
	Manufacturing overhead	2,700		2,700		2,700.00
	Marketing	210		210		3,015.0 *
	Administrative	2,250		2,250		2,130.0 **
	Interest	630		630		630
	Total fixed expenses	5,790		5,790		8,475.00
	Income before income taxes	2,455		1,520		1,004.2
	Income taxes (25%)	613.75		380		251.05
	Net income	$1,841.25		$1,140.00		$753.15
	*$210,000 + $2,805,000 = $3,015,000
	**$2,250,000 - $120,000 = $2,130,000
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 =			$5,790,000 ÷ 0.441 =		$13,129,252
b	Break-even point in dollar sales if the commission increases to 20%:
	Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$5,790,000 ÷ 0.391 =		$14,808,184
c	Break-even point in dollar sales if the company employs its own sales force:
	Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$8,475,000 ÷ 0.507 =		$16,715,976
2	In order to generate a $1,841,250 net income, the company must generate $2,455,000 in income before taxes. Therefore,
	Dollar sales to attain target =	(Target income before taxes + Fixed expenses) ÷ CM ratio
		($2,455,000+$5,790,000) ÷ 0.391
		$8,245,000 ÷ 0.391 =		$21,086,957
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
	0.609X + $5,790,000 = 0.493X + $8,475,000
	0.116X = $2,685,000
	X = $2,685,000 ÷ 0.116
	X = $23,146,552
	Thus, at a sales level of $23,146,552 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)	$                       8,245,000		$                                7,310,000		$           9,479,200
	Income before taxes (Part 1) (y)	$                       2,455,000		$                                1,520,000		$           1,004,200
	Degree of operating leverage: (X) ÷ (Y)	3.36		4.81		9.44