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				$	23,000,000
Manufacturing expenses:
Variable	$	10,350,000
Fixed overhead		3,220,000			13,570,000
Gross margin					9,430,000
Selling and administrative expenses:
Commissions to agents		3,450,000
Fixed marketing expenses		161,000	*
Fixed administrative expenses		2,080,000			5,691,000
Net operating income					3,739,000
Fixed interest expenses					805,000
Income before income taxes					2,934,000
Income taxes (30%)					880,200
Net income				$	2,053,800

*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 $3,450,000 per year, but that would be more than offset by the $4,600,000 (20% × $23,000,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,450,000 cost follows:

Salaries:
Sales manager	$	143,750
Salespersons		862,500
Travel and entertainment		575,000
Advertising		1,868,750
Total	$	3,450,000

“Super,” replied Karl. “And I noticed that the $3,450,000 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 $105,800 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

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Working-1
		Commission 15%	Commission 20%	Own Sales Force	Working
Sales. . . . . . . . . . . . . . . . . . .		$         23,000,000	$         23,000,000	$        23,000,000
Less: Variable Cost
Variable Manufacturing exp	$         10,350,000		$         10,350,000	$        10,350,000
Agents Commission	$           3,450,000		$           4,600,000	$           1,725,000	7.5% Commission
Total Variable Cost		$         13,800,000	$         14,950,000	$        12,075,000
Contribution Margin		$           9,200,000	$           8,050,000	$        10,925,000
Less: Fixed Cost
Fixed overhead. . . . . . . . . . . . . . .	$           3,220,000			$           3,220,000
Fixed marketing expenses. . .  . .  . .  . .  . . .	$               161,000			$           3,611,000	Additional fixed cost of 3450000
Fixed administrative expenses. . . . . . .	$           2,080,000			$           1,974,200	Saving audit fee of 105800
Total Fixed Cost		$           5,461,000	$           5,461,000	$           8,805,200
Net Operating Income		$           3,739,000	$           2,589,000	$           2,119,800
Fixed Interest Expenses		$               805,000	$               805,000	$              805,000
Income before income taxes		$           2,934,000	$           1,784,000	$           1,314,800
Income Tax 30%		$               880,200	$               535,200	$              394,440
Net Income		$           2,053,800	$           1,248,800	$              920,360
Part 1
a. BEP with 15% Comission
BEP=Fixed Cost/Contribution Margin
Fixed Cost (Fixed Cost+Interest)	$           6,266,000
Contribution Margin (CM/Sales)	40.00%
BEP (Fixed Cost/CM Ratio)	$         15,665,000
b. BEP with 20% Comission
Fixed Cost (Fixed Cost+Interest)	$           6,266,000
Contribution Margin (CM/Sales)	35.00%
BEP (Fixed Cost/CM Ratio)	$         17,902,857
c. BEP with own sales force
Fixed Cost (Fixed Cost+Interest)	$           9,610,200
Contribution Margin (CM/Sales)	47.50%
BEP (Fixed Cost/CM Ratio)	$         20,232,000
2. TO maintain budgeted Net Income
To maintain budgeted Net Income $2,053,800 i.e. $2,934,000 before tax income
(Fixed Cost+Target Profit)/Contribution Margin
Fixed Cost at 20% Commission	$           6,266,000	From b Above
Contribution Margin at 20% commission	35.00%	From b Above
Target Income before tax	$           2,934,000
Target Sales=($6,266,000+$2,934,000)/35%	$         26,285,714
3. Equal Net income
Let Sale be x
	20% Commission	Own Sales force
Let Sale be	x	x
Variable Cost Ratio (100-Margin Ratio)	65%	52.50%
Fixed Cost (From b and c)	$           6,266,000	$           9,610,200
0.65x+6266000=0.525x+9610200
x=3344200/0.125
x=$26,753,600 where net income will be equal
4. Degree of operating Leavarage
Contribution Margin/Income before tax
		Commission 15%	Commission 20%	Own Sales Force
Contribution Margin From working-1		$           9,200,000	$           8,050,000	$        10,925,000
Income before tax (From working -1)		$           2,934,000	$           1,784,000	$           1,314,800
Degree of operating leavarage		3.14	4.51	8.31