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				$	25,000,000
Manufacturing expenses:
Variable	$	11,250,000
Fixed overhead		3,500,000			14,750,000
Gross margin					10,250,000
Selling and administrative expenses:
Commissions to agents		3,750,000
Fixed marketing expenses		175,000	*
Fixed administrative expenses		2,160,000			6,085,000
Net operating income					4,165,000
Fixed interest expenses					875,000
Income before income taxes					3,290,000
Income taxes (30%)					987,000
Net income				$	2,303,000

*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’ 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 $3,750,000 per year, but that would be more than offset by the $5,000,000 (20% × $25,000,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,750,000 cost follows:

Salaries:
Sales manager	$	156,250
Salespersons		937,500
Travel and entertainment		625,000
Advertising		2,031,250
Total	$	3,750,000

“Super,” replied Karl. “And I noticed that the $3,750,000 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 $115,000 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

1)
a)	Sales		25000000
	Variable expenses:
	Variable manufacturing expenses	11250000		0.45
	Commissions to agents (15%)	3750000
	Total variable expenses		15000000
	Contribution margin		10000000
	Fixed costs:
	Fixed factory overhead	3500000
	Fixed marketing expenses	175000
	Fixed administrative expenses	2160000
	Total fixed expenses		5835000
	Net operating income		4165000
	Fixed interest expenses		875000
	Income before taxes		3290000
	Income tax at 30%		987000
	Net Income		2303000
	Contribution margin ratio = Contribution margin/Sales =		40%
	BEP Dollar sales = Fixed costs/CM Ratio = 6710000/40% =		$    1,67,75,000
b)	Sales		25000000
	Variable expenses:
	Variable manufacturing expenses	11250000		0.45
	Commissions to agents (20%)	5000000
	Total variable expenses		16250000
	Contribution margin		8750000
	Fixed costs:
	Fixed factory overhead	3500000
	Fixed marketing expenses	175000
	Fixed administrative expenses	2160000
	Total fixed expenses		5835000
	Net operating income		2915000
	Fixed interest expenses		875000
	Income before taxes		2040000
	Income tax at 30%		612000
	Net Income		1428000
	Contribution margin ratio = Contribution margin/Sales =		35%
	BEP Dollar sales = Fixed costs/CM Ratio = 6710000/35% =		$    1,91,71,429
c)	Sales		25000000
	Variable expenses:
	Variable manufacturing expenses	11250000
	Commissions to agents (7.5%)	1875000
	Total variable expenses		13125000
	Contribution margin		11875000
	Fixed costs:
	Fixed factory overhead	3500000
	Fixed marketing expenses	175000
	Fixed administrative expenses	2160000
	Incremental fixed expenses = 3750000-115000 =	3635000
	Total fixed expenses		9470000
	Net operating income		2405000
	Fixed interest expenses		875000
	Income before taxes		1530000
	Income tax at 30%		459000
	Net Income		1071000
	Contribution margin ratio = Contribution margin/Sales =		47.50%
	BEP Dollar sales = Fixed costs/CM Ratio =10345000/47.50% =		21778947
2)	Dollar sales required to get the same net income = (Desired EBT+Fixed expenses)/CM Ratio as same total contribution margin is to be earned = (3290000+6710000)/35% =	28571429
	CHECK:
	Sales		28571429
	Variable expenses:
	Variable manufacturing expenses	12857143
	Commissions to agents (20%)	5714286
	Total variable expenses		18571429
	Contribution margin		10000000
	Fixed costs:
	Fixed factory overhead	3500000
	Fixed marketing expenses	175000
	Fixed administrative expenses	2160000
	Total fixed expenses		5835000
	Net operating income		4165000
	Fixed interest expenses		875000
	Income before taxes		3290000
	Income tax at 30%		987000
	Net Income		2303000
3)	For getting the same NI, EBT should be equal
	EBT with 20% sales commission = S*35%-6710000
	EBT with own sales force = S*47.50%-10345000
	Equating we have
	S*0.35-6710000=S*0.47.5-10345000
	Solving for S, the required sales
	0.12.5*S = 3635000
	S = 3635000/0.12.5 =	29080000
	CHECK:
	With 20% commission to agents:
	Sales		29080000
	Variable expenses:
	Variable manufacturing expenses	13086000
	Commissions to agents (20%)	5816000
	Total variable expenses		18902000
	Contribution margin		10178000
	Fixed costs:
	Fixed factory overhead	3500000
	Fixed marketing expenses	175000
	Fixed administrative expenses	2160000
	Total fixed expenses		5835000
	Net operating income		4343000
	Fixed interest expenses		875000
	Income before taxes		3468000
	Income tax at 30%		1040400
	Net Income		2427600
	With own sales force:
	Sales		29080000
	Variable expenses:
	Variable manufacturing expenses	13086000
	Commissions to agents (7.5%)	2181000
	Total variable expenses		15267000
	Contribution margin		13813000
	Fixed costs:
	Fixed factory overhead	3500000
	Fixed marketing expenses	175000
	Fixed administrative expenses	2160000
	Incremental fixed expenses = 3750000-115000 =	3635000
	Total fixed expenses		9470000
	Net operating income		4343000
	Fixed interest expenses		875000
	Income before taxes		3468000
	Income tax at 30%		1040400
	Net Income		2427600
4)	Degree of Operating leverage = Contribution/EBT	Contribution	EBT	DOL
a)	Agent's commission at 15%	10000000	3290000	3.04
b)	Agent's commission at 20%	8750000	2040000	4.29
c)	Own sales force	11875000	1530000	7.76