Pittman Company is a small but growing manufacturer of telecommunications equipm
ID: 2529344 • 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 14% 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 $ 18,400,000 Manufacturing expenses: Variable $ 7,600,000 Fixed overhead 2,660,000 10,260,000 Gross margin 8,140,000 Selling and administrative expenses: Commissions to agents 2,576,000 Fixed marketing expenses 200,000* Fixed administrative expenses 2,200,000 4,976,000 Net operating income 3,164,000 Fixed interest expenses 620,000 Income before income taxes 2,544,000 Income taxes (20%) 508,800 Net income $ 2,035,200 *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’ 14% 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 19%.” “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 19% 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 8.3% 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 $2,576,000 per year, but that would be more than offset by the $3,496,000 (19% × $18,400,000) that we would avoid on agents’ commissions.” The breakdown of the $2,576,000 cost follows: Salaries: Sales manager $ 180,000 Salespersons 1,000,000 Travel and entertainment 720,000 Advertising 676,000 Total $ 2,576,000 “Super,” replied Karl. “And I noticed that the $2,576,000 is just what we’re paying the agents under the old 14% commission rate.” “It’s even better than that,” explained Barbara. “We can actually save $115,000 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.”
2. Assume that Pittman Company decides to continue selling through agents and pays the 19% 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.)
Explanation / Answer
2.
Volume of sales required = (Fixed costs + Target income)/Contribution margin ratio
Taget income = Net income/(1 - Tax rate) = $2035200/(1 - 0.20) = $2035200/0.80 = $2544000
Volume of sales required = ($5680000 + $2544000)/0.397 = $8224000/0.397 = $20715365.23 = $20715365
Workings:
Sales 18400000 Variable costs: Manufacturing expenses 7600000 Commission to agents (19%) 3496000 Total variable costs 11096000 Contribution margin 7304000 Fixed costs: Manufacturing expenses 2660000 Marketing expenses 200000 Administrative expenses 2200000 Interest expenses 620000 Total fixed costs 5680000 Income before taxes 1624000 Income tax expense (20%) 324800 Net income 1299200 Contribution margin ratio 0.397 Contribution margin/Sales