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%.

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 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.)

Answer 1

1) Firstly we need to prepare the income statement for all the three situations which is shown as follows:-

Income Statement
For the Year Ended December 31 (Amounts in $)

Particulars	15% Commission	20% Commission	Own sales force
Sales (A)	21,400,000	21,400,000	21,400,000
Less: Variable Expenses
Manufacturing expenses	(8,100,000)	(8,100,000)	(8,100,000)
Sales Commissions (15%, 20% and 8.2% of sales)	(3,210,000)	(4,280,000)	(1,754,800)
Contribution Margin (B)	10,090,000	9,020,000	11,545,200
Less: Fixed Expenses
Manufacturing overhead	(3,060,000)	(3,060,000)	(3,060,000)
Marketing expenses	(300,000)	(300,000)	(3,510,000)*
Administrative Expenses	(2,700,000)	(2,700,000)	(2,535,000)**
Interest	(720,000)	(720,000)	(720,000)
Total Fixed Expenses (C)	(6,780,000)	(6,780,000)	(9,825,000)
Income before income taxes	3,310,000	2,240,000	1,720,200
Income Taxes (20%)	(662,000)	(448,000)	(344,040)
Net Income	2,648,000	1,792,000	1,376,160
Contribution Margin Ratio (B/A*100)	47.150%	42.150%	53.950%

* Marketing Expenses under own sales force = $300,000+$3,210,000 = $3,510,000

** Administrative Expenses under own sales force = $2,700,000 - $165,000 = $2,535,000

a) Break Even point in dollars = Total Fixed Expenses/CM Ratio (C/B)

= $6,780,000/47.150% = $14,379,639

b) Break Even point in dollars = Total Fixed Expenses/CM Ratio (C/B)

= $6,780,000/42.150% = $16,085,409

c) Break Even point in dollars = Total Fixed Expenses/CM Ratio (C/B)

= $9,825,000/53.950% = $18,211,307

2) In order to generate a $2,648,000 net income, the company must generate $3,310,000 in income before taxes. Therefore

Dollar sales to attain target = (Target Income before taxes+Fixed Expenses)/CM Ratio

= ($3,310,000+$6,780,000)/47.150%

= $10,090,000/47.150% = $21,399,788