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 19% 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			$	17,200,000
Manufacturing expenses:
Variable	$	7,400,000
Fixed overhead		2,500,000		9,900,000
Gross margin				7,300,000
Selling and administrative expenses:
Commissions to agents		3,268,000
Fixed marketing expenses		160,000*
Fixed administrative expenses		2,000,000		5,428,000
Net operating income				1,872,000
Fixed interest expenses				580,000
Income before income taxes				1,292,000
Income taxes (25%)				323,000
Net income			$	969,000
*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’ 19% 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 24%.” “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 24% 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 6.0% 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 $3,268,000 per year, but that would be more than offset by the $4,128,000 (24% × $17,200,000) that we would avoid on agents’ commissions.” The breakdown of the $3,268,000 cost follows: Salaries: Sales manager $ 140,000 Salespersons 800,000 Travel and entertainment 560,000 Advertising 1,768,000 Total $ 3,268,000

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 19%.

Breakeven point dollars in sales = ?

b. The agents’ commission rate is increased to 24%

Breakeven point dollars in sales = ?

c. The company employs its own sales force.

Breakeven point dollars in sales = ?

Answer 1

Breakeven point is calculated as the Fixed Costs/Contribution Margin

Question (a)

Fixed Costs = Fixed Overheads + Fixed Marketing Expenses + Fixed Administrative Expenses + Fixed Interest Expenses

= 2,500,000 + 160,000 + 2,000,000 + 580,000 = $5,240,000

Contribution Margin = (Sales - Commission to Agents - Variable Costs)/Sales = (17,200,000 -3,268,000 - 7,400,000)/17,200,000 = 37.977%

Break Even Point = 5,240,000/37.977% = $13,797,918

Question (b)

If the commission rate is incrased to 24%, the Contribution Margin Falls by 5%.

New Contribution Margin = 32.977%

New Break Even Point = 5,240,000/37.977% = $15,889,863

Question (c)

If a owns sales force is used, the new commission is 6% as compared to 19%. Hence the Contribution Margin increases by 13%.

New Contribution Margin = 50.977%

The Fixed Costs will increase by 3,268,000, resulting in a new fixed cost of 8,508,000

Hence the new Break Even Point = 8,508,000/50.977% = $16,689,880