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 18% 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 $ 16,900,000 Manufacturing expenses: Variable $ 7,350,000 Fixed overhead 2,460,000 9,810,000 Gross margin 7,090,000 Selling and administrative expenses: Commissions to agents 3,042,000 Fixed marketing expenses 150,000* Fixed administrative expenses 1,950,000 5,142,000 Net operating income 1,948,000 Fixed interest expenses 570,000 Income before income taxes 1,378,000 Income taxes (20%) 275,600 Net income $ 1,102,400 *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’ 18% 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 23%.” “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 23% 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 6.3% 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 $3,042,000 per year, but that would be more than offset by the $3,887,000 (23% × $16,900,000) that we would avoid on agents’ commissions.” The breakdown of the $3,042,000 cost follows: Salaries: Sales manager $ 130,000 Salespersons 750,000 Travel and entertainment 520,000 Advertising 1,642,000 Total $ 3,042,000 “Super,” replied Karl. “And I noticed that the $3,042,000 is just what we’re paying the agents under the old 18% commission rate.” “It’s even better than that,” explained Barbara. “We can actually save $90,000 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.” Assume that Pittman Company decides to continue selling through agents and pays the 23% 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 23% 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 18%. (Round your answer to 2 decimal places.) b. The agents’ commission rate is increased to 23%. (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. With sales commission @23% the vaolume of sales required to achieve the same net income as contanied in the budgeted income statement = $19,421,068

Working:

	Amount	%
Sales	16900000	100.00%
Variable Expenses
Manufacturing costs	7350000	43.49%
Sales commision (23%)	3887000	23.00%
Total variable expenses	11237000	66.49%
Contribution margin	5663000	33.51%
Fixed expenses
Manufacturing	2460000	14.56%
Marketing	150000	0.89%
Administration	1950000	11.54%
Interest expenses	570000	3.37%
Total fixed expenses	5130000
Net income before taxes	533000	3.15%
Income tax expense (20%)	106600
Net income	426400
Contribution margin		33.51%
Fixed expenses		5130000
Desired net income before income taxes		1378000
Total contribution needed		6508000
Volume of sales requiredto achieve this		19421068
(6,508,000 / 33.51%)

3.

Diference in CM ratio (50.21 - 33.51)		16.70%
Diference in fixed expenses		3042000
Indifference point of sales between the options		18215569

Working:

TRUMP COMPANY
Contribution income statement - with own sales personnel
	Amount	%
Sales	18215569	100.00%
Variable Expenses
Manufacturing costs	7921951	43.49%
Sales commision (6.3%)	1147581	6.30%
Total variable expenses	9069532	49.79%
Contribution margin	9146037	50.21%
Fixed expenses
Manufacturing	2460000	13.50%
Marketing	150000	0.82%
Administration	4992000	27.41%
Interest expenses	570000	3.13%
Total fixed expenses	8172000
Net income before taxes	974037.2	5.35%
Income tax expense (20%)	194807.4
Net income	779230

4.

		CM	Net operating income	Operating Leverage
					a	Agents' commission at 18%	6508000	5700000	1.14
b	Agents' commission at 23%	5663000	5700000	0.99
c	The company employs its own sales force	9146037	1544037	5.92