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			$	21,400,000
Manufacturing expenses:
Variable	$	8,100,000
Fixed overhead		3,060,000		11,160,000
Gross margin				10,240,000
Selling and administrative expenses:
Commissions to agents		3,210,000
Fixed marketing expenses		300,000*
Fixed administrative expenses		2,700,000		6,210,000
Net operating income				4,030,000
Fixed interest expenses				720,000
Income before income taxes				3,310,000
Income taxes (20%)				662,000
Net income			$	2,648,000

*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 8.2% 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 $3,210,000 per year, but that would be more than offset by the $4,280,000 (20% × $21,400,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,210,000 cost follows:

   

Salaries:
Sales manager	$	280,000
Salespersons		1,500,000
Travel and entertainment		1,120,000
Advertising		310,000
Total	$	3,210,000

“Super,” replied Karl. “And I noticed that the $3,210,000 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 $165,000 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%.

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 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.)

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.)

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.)

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

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

Answer 1

1.

a.

PITMAN COMPANY
Contribution income statement - with 15% sales commision
	Amount	%
Sales	21400000	100.00%
Variable Expenses
Manufacturing costs	8100000	37.85%
Sales commision (15%)	3210000	15.00%
Total variable expenses	11310000	52.85%
Contribution margin	10090000	47.15%
Fixed expenses
Manufacturing	3060000	14.30%
Marketing	300000	1.40%
Administration	2700000	12.62%
Interest expenses	720000	3.36%
Total fixed expenses	6780000
Net income before taxes	3310000	15.47%
Income tax expense (20%)	662000
Net income	2648000

c.

PITMAN COMPANY
Contribution income statement - with own sales personnel
	Amount	%
Sales	21400000	100.00%
Variable Expenses
Manufacturing costs	8100000	37.85%
Sales commision (8.2%)	1754800	8.20%
Total variable expenses	9854800	46.05%
Contribution margin	11545200	53.95%
Fixed expenses
Manufacturing	3060000	14.30%
Sales Salaries	3210000	15.00%
Marketing	300000	1.40%
Administration	2535000	11.85%
Total fixed expenses	9105000	42.55%
Net operating income	2440200	11.40%
Interest Expenses	720000
Income before taxes	1720200
Income Tax Expense (20%)	344040
Net Income	1376160
Own sales personnel have to be paid 8.2% commision on sales

2.

PITMAN COMPANY
Contribution income statement - with 20% sales commision
	Amount	%
Sales	21400000	100.00%
Variable Expenses
Manufacturing costs	8100000	37.85%
Sales commision (20%)	4280000	20.00%
Total variable expenses	12380000	57.85%
Contribution margin	9020000	42.15%
Fixed expenses
Manufacturing	3060000	14.30%
Marketing	300000	1.40%
Administration	2700000	12.62%
Interest expenses	720000
Total fixed expenses	6780000	31.68%
Net income before taxes	2240000
Income Tax (20%)	448000	2.09%
Net income	1792000
Contribution margin		42.15%
Fixed expenses		6780000
Desired net operating income		3310000
Total contribution needed		10090000
Volume of sales requiredto achieve this		23938316
(10,090,000 / 42.15%)

4.

		CM	Net operating income	Operating Leverage
a	Agents' commission at 15%	10090000	4030000	2.50
b	Agents' commission at 23%	9020000	2960000	3.05
c	The company employs its own sales force	11545200	2440200	4.73