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				$	19,500,000
Manufacturing expenses:
Variable	$	8,775,000
Fixed overhead		2,730,000			11,505,000
Gross margin					7,995,000
Selling and administrative expenses:
Commissions to agents		2,925,000
Fixed marketing expenses		136,500	*
Fixed administrative expenses		1,940,000			5,001,500
Net operating income					2,993,500
Fixed interest expenses					682,500
Income before income taxes					2,311,000
Income taxes (30%)					693,300
Net income				$	1,617,700

*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 $2,925,000 per year, but that would be more than offset by the $3,900,000 (20% × $19,500,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,925,000 cost follows:

Salaries:
Sales manager	$	121,875
Salespersons		731,250
Travel and entertainment		487,500
Advertising		1,584,375
Total	$	2,925,000

“Super,” replied Karl. “And I noticed that the $2,925,000 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 $89,700 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

				15% Commission	20% Commission	Own sales Force
	Sales			19500000	19500000	19500000
	Variable expenses:
	Manufacturing			8775000	8775000	8775000
	Commissions			2925000	3900000	1462500
				(19500000*15%)	(19500000*20%)	(19500000*7.5%)
	Total variable expenses			11700000	12675000	10237500
	Contribution margin			7800000	6825000	9262500
	Fixed expenses:
	Manufacturing overhead			2730000	2730000	2730000
	Marketing			136500	136500	136500
	Administrative			1940000	1940000	1940000
	Additional cost			0	0	2925000
	Total fixed expenses			4806500	4806500	7731500
	Income before taxes			2993500	2018500	1531000
	Tax @30%			898050	605550	459300
	Net income			2095450	1412950	1071700
1	Break-even point in $ =Fixed expenses/Contribution margin ratio
	Contribution margin ratio=Contribution margin/Sales
a.	Contribution margin ratio=7800000/19500000=0.4
	Break-even point in $ =4806500/0.4=$ 120116250
b.	Contribution margin ratio=6825000/19500000=0.35
	Break-even point in $ =4806500/0.35=$ 13732857
c.	Contribution margin ratio=9262500/19500000=0.475
	Break-even point in $ =7731500/0.475=$ 16276842
2	$ sales required to attain desired profit=(Desired profit+Fixed expenses)/Contribution margin ratio=(23110000+4806500)/0.35=$ 79761429
3	Total cost under both alternatives will be same
	Assume sales in $=x
	Total cost under 20% commission=(0.65*x)+4806500
	Total cost under own sales force=(0.525*x)+7731500
	0.65x+4806500=0.525x+7731500
	x=23400000
	Sales in $ =23400000
4	Degree of operating leverage=Contribution margin/Income before taxes
				15% Commission	20% Commission	Own sales Force
	Contribution margin			7800000	6825000	9262500
	Income before taxes			2993500	2018500	1531000
	Degree of operating leverage			2.61	3.38	6.05