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 “Super,” replied Karl. “And I noticed that the $3,268,000 is just what we’re paying the agents under the old 19% commission rate.” “It’s even better than that,” explained Barbara. “We can actually save $145,000 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.”

3. Determine the volume of sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 24% 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.)

Answer 1

Indifference point at which dollar sales is equal between alternative of 24% commission
and employing own sales force
				24% commission	Own sales force	Difference
difference in fixed cost				4660000	7783000	3123000
difference in margin ratio				32.98	56.98	24.00
Required sales are			=	3123000/24%
				12012500
				a=19% commission	b=24% commission	Own sales force
Sales				17200000	17200000	17200000
Less : Variable cost
Variable Manufacturing expenses				7400000	7400000	7400000
Variable selling expenses(Commission)				3268000	4128000	0
Total Variable expense				10668000	11528000	7400000
	Contribution Margin			6532000	5672000	9800000
	Margin Ratio			37.976744	32.976744	56.976744
Fixed cost
Manufacturing overhead				2500000	2500000	2500000
Selling expenses				160000	160000	3428000
Administrative expenses				2000000	2000000	1855000
	Total fixed cost			4660000	4660000	7783000