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 $ 21,000,000

Manufacturing expenses:

Variable $ 9,450,000

Fixed overhead 2,940,000 12,390,000

Gross margin 8,610,000

Selling and administrative expenses:

Commissions to agents 3,150,000

Fixed marketing expenses 147,000 *

Fixed administrative expenses 2,000,000 5,297,000

Net operating income 3,313,000

Fixed interest expenses 735,000

Income before income taxes 2,578,000

Income taxes (30%) 773,400

Net income $ 1,804,600

*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 $3,150,000 per year, but that would be more than offset by the $4,200,000 (20% × $21,000,000) that we would avoid on agents’ commissions.” The breakdown of the $3,150,000 cost follows: Salaries: Sales manager $ 131,250 Salespersons 787,500 Travel and entertainment 525,000 Advertising 1,706,250 Total $ 3,150,000 “Super,” replied Karl. “And I noticed that the $3,150,000 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 $96,600 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

Before proceeding with the solution, it is helpful first to restructure the data into contribution format for each of the three alternatives. (The data in the statements below are in thousands.)
	15%Commission		20% Commission		Own Sales Force
Sales	$21,000	100%	$21,000	100%	$21,000.00	100.00%
Variable expenses:
Manufacturing	9,450		9,450		9,450.00
Commissions (15%, 20%, 7.5%)	3,150		4,200		1,575.00
Total variable expenses	12,600	60.0%	13,650	65.0%	11,025.00	52.5%
Contribution margin	8,400	40.0%	7,350	35.0%	9,975.0	47.5%
Fixed expenses:
Manufacturing overhead	2,940		2,940		2,940.00
Marketing	147		147		3,297.0 *
Administrative	2,000		2,000		1,903.4 **
Interest	735		735		735
Total fixed expenses	5,822		5,822		8,875.40
Income before income taxes	2,578		1,528		1,099.6
Income taxes (30%)	773.4		458.4		329.88
Net income	$1,804.60		$1,069.60		$769.72
*$147,000 + $3,150,000 = $3,297,000
**$2,000,000 - $96,600 = $1,903,400
When the income before taxes is zero, income taxes will also be zero and net income will be zero. Therefore, the break-even calculations can be based on the income before taxes.
							Break-even point in dollar sales if the commission remains 15%:
Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$5,822,000 ÷ 0.40 =		$14,555,000
Break-even point in dollar sales if the commission increases to 20%:
Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$5,822,000 ÷ 0.35 =		$16,634,286
Break-even point in dollar sales if the company employs its own sales force:
Dollar sales to break even =	Fixed expenses ÷ CM ratio =			$8,875,400 ÷ 0.475 =		$18,685,053
In order to generate a $1,804,600 net income, the company must generate $2,578,000 in income before taxes. Therefore,
Dollar sales to attain target =	(Target income before taxes + Fixed expenses) ÷ CM ratio
	($2,578,000+$5,822,000) ÷ 0.35
	$8,400,000 ÷ 0.35 =		$24,000,000
To determine the volume of sales at which net income would be equal under either the 20% commission plan or the company sales force plan, we find the volume of sales where costs before income taxes under the two plans are equal. See below
							X = Total sales revenue
0.65X + $5,822,000 = 0.525X + $8,875,400
0.125X = $3,053,400
X = $3,053,400 ÷ 0.125
X = $24,427,200
Thus, at a sales level of $24,427,200 either plan would yield the same income before taxes and net income. Below this sales level, the commission plan would yield the largest net income; above this sales level, the sales force plan would yield the largest net income.
							a., b., and c.
	15% Commission		20% Commission		Own Sales Force
Contribution margin (Part 1) (x)	$                       8,400,000		$                                7,350,000		$           9,975,000
Income before taxes (Part 1) (y)	$                       2,578,000		$                                1,528,000		$           1,099,600
Degree of operating leverage: (X) ÷ (Y)	3.26		4.81		9.07