Pittman Company is a small but growing manufacturer of telecommunications equipm
ID: 2587051 • 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:
“Super,” replied Karl. “And I noticed that the $3,000,000 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 $92,000 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 Company Budgeted Income Statement For the Year Ended December 31 Sales Manufacturing expenses: $20,000,000 $9,000,000 Variable Fixed overhead 2,800,000 11,800,000 8,200,000 Gross margin Selling and administrative expenses: Commissions to agents Fixed marketing expenses Fixed administrative expenses 3,000,000 140,000* 1,960,000 Net operating income Fixed interest expenses Income before income taxes Income taxes (30%) Net income 5,100,000 3,100,000 700,000 2,400,000 720.000 $1,680,000 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 $3,000,000 per year, but that would be more than offset by the $4,000,000 (20% x $20,000,000) that we would avoid on agents commissions." The breakdown of the $3,000,000 cost follows Salaries: $ 125,000 750,000 500,000 1,625,000 $3,000,000 Sales manager Salespersons Travel and entertainment Advertising TotalExplanation / Answer
Pittman Company Requirement 1 Breakeven Point in dollar sales a=15% commission b=20% commission Own sales force Sales 20000000 20000000 20000000 Less : Variable cost Variable Manufacturing expenses 9000000 9000000 9000000 Variable selling expenses(Commission) 3000000 4000000 0 Total Variable expense 12000000 13000000 9000000 Contribution Margin 8000000 7000000 11000000 Margin Ratio 40 35 55 Fixed cost Manufacturing overhead 2800000 2800000 2800000 Selling expenses 140000 140000 3140000 Administrative expenses 1960000 1960000 1868000 Total fixed cost 4900000 4900000 7808000 Break even sales in dollar =Total fixed cost/Margin ratio 12250000 14000000 14196364 2 Assuming increased commission of 20% and same operating profit as budgeted b=20% commission Sales 20000000 Less : Variable cost Variable Manufacturing expenses 9000000 Variable selling expenses(Commission) 4000000 Total Variable expense 13000000 Contribution Margin 7000000 Margin Ratio 35 Fixed cost Manufacturing overhead 2800000 Selling expenses 140000 Administrative expenses 1960000 Total fixed cost 4900000 To get the same Net operating Income we need to work out revised contribution Net Operating Income 3100000 Add : Fixed expenses 4900000 Total contirbution required 8000000 Required sales are = =8000000/35% 22857143 3 Indifference point at which dollar sales will be equal between alternative of 20% commission and employing own sales force 20% commission Own sales force Difference difference in fixed cost 4900000 7808000 2908000 difference in margin ratio 35% 55% 20% Required sales are = 2908000/20% 14540000 4 Computation of operating leverage Operating Leverage= contribution margin/Income before taxes a=15% commission b=20% commission Own sales force Sales 20000000 20000000 20000000 Less : Variable cost Variable Manufacturing expenses 9000000 9000000 9000000 Variable selling expenses(Commission) 3000000 4000000 0 Total Variable expense 12000000 13000000 9000000 Contribution Margin A 8000000 7000000 11000000 Margin Ratio 40 35 55 Fixed cost Manufacturing overhead 2800000 2800000 2800000 Selling expenses 140000 140000 3140000 Administrative expenses 1960000 1960000 1868000 Total fixed cost 4900000 4900000 7808000 Operating profit 3100000 2100000 3192000 Less : Fixed Interest expenses 700000 700000 700000 Income before taxes B 2400000 1400000 2492000 Operating Leverage = A/B 3.33 5.00 4.41