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.”

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 19%. (Round your answer to 2 decimal places.)

b. The agents’ commission rate is increased to 24%. (Round your answer to 2 decimal places.)

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

Answer 1

Operating Leverage = Contribution Margin / Net Operating Income.

a) The agents’ commission rate remains unchanged at 19%

Agents commission =17200000 *19/100 = $$3,268,000.

Net Operating Income : $1,872,000.

Operating Leverage = Contribution Margin / Net Operating Income.

Operating Leverage =  $3,268,000 / $1,872,000

= 1.75 or 175 %

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

Agents commission =17200000 *24/100 = $4,128,000

Net Operating Income : $1,872,000.

Operating Leverage = Contribution Margin / Net Operating Income.

Operating Leverage =  $4,128,000 / $ 1,872,000

= 2.21 or 221%

c)  The company employs its own sales force.

Sales forces expenses = $3,268,000

(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 ).

Net Operating Income :

$1,872,000.-+145,000 (Fees reduced due eliminating auditing of Agents books of accounts)

= $ 2,017,000

Operating Leverage = Contribution Margin / Net Operating Income.

Operating Leverage =  $3,268,000 / $ 2,017,000

= 1.62 or 162 %