Question

Outback Outfitters is a manufacturer of recreational equipment. It has been experiencing an average growth rate of 20% in sales over the past 5 years. It is August 31 and the financial controller has just prepared the company’s budgeted income statement for next year. The company has no sales force of its own and outsourcing its selling and marketing functions to an independent sales agents. The commission paid to the agent is 12% on sales for all the different products the company sold. The statement follows:

Outback Outfitters
Budgeted Income Statement
For the Year Ended December 31 (in thousand dollars)
Sales		$100,000
Manufacturing expenses:
Variable	$40,000
Fixed overhead	20,000	60,000
Gross margin		40,000
Selling and administrative expenses:
Commissions to agents	12,000
Fixed marketing expenses	1,000
Fixed administrative expenses	12,000	25,000
Net operating income		$15,000

When the financial controller handed the statement to the CEO, the CEO informed the controller that the sales agent demanded an increase in the commission rate to 16% next year to cover the increasing expenses in marketing and selling the products of Outback Outfitters.

The CEO concerns that the sales agent might ask for further increase in the commission rate in the future and would like to set up its own sales team. He asks the help of the financial controller and he gathers the following information for setting up the sales team:

Commission rate to own sales team 8%

Annual salaries paid to sales manager	$    600,000
Annual salaries paid to salespersons	3,600,000
Travel and entertainment	2,400,000
Advertising	4,000,000
Total additional fixed expenses	$10,600,000

Required:

a. Prepare a contribution margin income statement for next year at the 16% commission rate.

b. Calculate the contribution margin ratio and break-even in dollar sales for next year assuming:

(1) Commission rate remains at 12%.

(2) Commission rate is increased to 16%.

c. Determine the volume of sales under 16% commission rate that would be required to generate the same net operating income under the 12% commission rate. Compute the margin of safety percentage under 16% commission rate.

d. Calculate the contribution margin ratio, break-even dollar sales and margin of safety if the company employs its own sales team.

e. Determine the volume of sales at which the net operating income would be equal regardless of whether the company sells through agents at 16% commission rate or employs its own sales team.

f. What is meant by the term operating leverage? Calculate the degree of operating leverage that the company would expect to have for next year assuming the company (1) sells through agents at 16% commission rate and (2) employs its own sales team.

g. Based on the data in (a) through (f) above, make a recommendation as to whether the company should continue to use sales agent (at 16% commission rate) or employ its own sales team. Give reasons for your answer.

Answer 1

a	Budgeted Income Statement (16% commission rate)
	For the Year Ended December 31 (in thousand dollars)
	Sales		100,000.00
	Manufacturing expenses:
	Variable	40,000.00
	Fixed overhead	20,000.00	60,000.00
	Gross margin		40,000.00
	Selling and administrative expenses:
	Commissions to agents	16,000.00
	Fixed marketing expenses	1,000.00
	Fixed administrative expenses	12,000.00	29,000.00
	Net operating income		11,000.00

b		(1) At 12% Commission	(2) At 16% Commission
	Sales	100,000.00	100,000.00
	Variable Cost:
	Variable	40,000.00	40,000.00
	Commissions to agents	12,000.00	16,000.00
	Contribution	48,000.00	44,000.00
	Contribution Margin	48%	44%
	Fixed Cost	33,000.00	33,000.00
	Break-even sales (Fixed Costs/Contribution Margin)	68,750.00	75,000.00

c	As per Part (b) we can see Net profit under 12% commission is $15,000 and $11,000 under 16% commission. To generate the same profit, the contribution has to increase by $4,000 (15,0000 - 11,000)
	Additional Contribution Required	4,000.00
	Contribution Margin	44%
	Additonal Sales Required	9,090
	Existing Sales	100,000.00
	Total Sales Required	109,090
	Income Statement
	Total Sales	109,090
	Contribution Margin	44%
	Contribution	48,000.00
	Fixed Cost	33,000.00
	Net Profit	15,000.00
	Sales	100,000.00
	Breakeven as calculated in part (b)	75,000.00
	Margin of safety (Existing sales - Breakeven sales)/Existing sales	25%