Pittman Company is a small but growing manufacturer of telecommunications equipm
ID: 2519750 • Letter: P
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:
*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 $3,750,000 per year, but that would be more than offset by the $5,000,000 (20% × $25,000,000) that we would avoid on agents’ commissions.”
The breakdown of the $3,750,000 cost follows:
“Super,” replied Karl. “And I noticed that the $3,750,000 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 $115,000 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.
Pittman CompanyBudgeted Income Statement
For the Year Ended December 31 Sales $ 25,000,000 Manufacturing expenses: Variable $ 11,250,000 Fixed overhead 3,500,000 14,750,000 Gross margin 10,250,000 Selling and administrative expenses: Commissions to agents 3,750,000 Fixed marketing expenses 175,000 * Fixed administrative expenses 2,160,000 6,085,000 Net operating income 4,165,000 Fixed interest expenses 875,000 Income before income taxes 3,290,000 Income taxes (30%) 987,000 Net income $ 2,303,000
Explanation / Answer
1) a) Sales 25000000 Variable expenses: Variable manufacturing expenses 11250000 0.45 Commissions to agents (15%) 3750000 Total variable expenses 15000000 Contribution margin 10000000 Fixed costs: Fixed factory overhead 3500000 Fixed marketing expenses 175000 Fixed administrative expenses 2160000 Total fixed expenses 5835000 Net operating income 4165000 Fixed interest expenses 875000 Income before taxes 3290000 Income tax at 30% 987000 Net Income 2303000 Contribution margin ratio = Contribution margin/Sales = 40% BEP Dollar sales = Fixed costs/CM Ratio = 6710000/40% = $ 1,67,75,000 b) Sales 25000000 Variable expenses: Variable manufacturing expenses 11250000 0.45 Commissions to agents (20%) 5000000 Total variable expenses 16250000 Contribution margin 8750000 Fixed costs: Fixed factory overhead 3500000 Fixed marketing expenses 175000 Fixed administrative expenses 2160000 Total fixed expenses 5835000 Net operating income 2915000 Fixed interest expenses 875000 Income before taxes 2040000 Income tax at 30% 612000 Net Income 1428000 Contribution margin ratio = Contribution margin/Sales = 35% BEP Dollar sales = Fixed costs/CM Ratio = 6710000/35% = $ 1,91,71,429 c) Sales 25000000 Variable expenses: Variable manufacturing expenses 11250000 Commissions to agents (7.5%) 1875000 Total variable expenses 13125000 Contribution margin 11875000 Fixed costs: Fixed factory overhead 3500000 Fixed marketing expenses 175000 Fixed administrative expenses 2160000 Incremental fixed expenses = 3750000-115000 = 3635000 Total fixed expenses 9470000 Net operating income 2405000 Fixed interest expenses 875000 Income before taxes 1530000 Income tax at 30% 459000 Net Income 1071000 Contribution margin ratio = Contribution margin/Sales = 47.50% BEP Dollar sales = Fixed costs/CM Ratio =10345000/47.50% = 21778947 2) Dollar sales required to get the same net income = (Desired EBT+Fixed expenses)/CM Ratio as same total contribution margin is to be earned = (3290000+6710000)/35% = 28571429 CHECK: Sales 28571429 Variable expenses: Variable manufacturing expenses 12857143 Commissions to agents (20%) 5714286 Total variable expenses 18571429 Contribution margin 10000000 Fixed costs: Fixed factory overhead 3500000 Fixed marketing expenses 175000 Fixed administrative expenses 2160000 Total fixed expenses 5835000 Net operating income 4165000 Fixed interest expenses 875000 Income before taxes 3290000 Income tax at 30% 987000 Net Income 2303000 3) For getting the same NI, EBT should be equal EBT with 20% sales commission = S*35%-6710000 EBT with own sales force = S*47.50%-10345000 Equating we have S*0.35-6710000=S*0.47.5-10345000 Solving for S, the required sales 0.12.5*S = 3635000 S = 3635000/0.12.5 = 29080000 CHECK: With 20% commission to agents: Sales 29080000 Variable expenses: Variable manufacturing expenses 13086000 Commissions to agents (20%) 5816000 Total variable expenses 18902000 Contribution margin 10178000 Fixed costs: Fixed factory overhead 3500000 Fixed marketing expenses 175000 Fixed administrative expenses 2160000 Total fixed expenses 5835000 Net operating income 4343000 Fixed interest expenses 875000 Income before taxes 3468000 Income tax at 30% 1040400 Net Income 2427600 With own sales force: Sales 29080000 Variable expenses: Variable manufacturing expenses 13086000 Commissions to agents (7.5%) 2181000 Total variable expenses 15267000 Contribution margin 13813000 Fixed costs: Fixed factory overhead 3500000 Fixed marketing expenses 175000 Fixed administrative expenses 2160000 Incremental fixed expenses = 3750000-115000 = 3635000 Total fixed expenses 9470000 Net operating income 4343000 Fixed interest expenses 875000 Income before taxes 3468000 Income tax at 30% 1040400 Net Income 2427600 4) Degree of Operating leverage = Contribution/EBT Contribution EBT DOL a) Agent's commission at 15% 10000000 3290000 3.04 b) Agent's commission at 20% 8750000 2040000 4.29 c) Own sales force 11875000 1530000 7.76