Pittman Company is a small but growing manufacturer of telecommunications equipm
ID: 2601749 • 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 12% for all items sold.
Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year. The statement follows:
As Barbara handed the statement to Karl Vecci, Pittman’s president, she commented, “I went ahead and used the agents’ 12% 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 17%.”
“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 17% 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 8.1% 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 $2,136,000 per year, but that would be more than offset by the $3,026,000 (17% × $17,800,000) that we would avoid on agents’ commissions.”
“Super,” replied Karl. “And I noticed that the $2,136,000 is just what we’re paying the agents under the old 12% commission rate.”
“It’s even better than that,” explained Barbara. “We can actually save $105,000 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 costs 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.”
Compute Pittman Company’s break-even point in dollar sales for next year assuming: (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places and final answer to the nearest dollar amount.)
The agents’ commission rate remains unchanged at 12%.
The agents’ commission rate is increased to 17%.
The company employs its own sales force.
Assume that Pittman Company decides to continue selling through agents and pays the 17% 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.)
Determine the volume of sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 17% commission rate) or employs its own sales force. (Enter your answer in whole dollars and not in thousands. Round CM ratio to 3 decimal places.)
Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming:
The agents’ commission rate remains unchanged at 12%. (Round your answer to 2 decimal places.)
The agents’ commission rate is increased to 17%. (Round your answer to 2 decimal places.)
The company employs its own sales force. (Round your answer to 2 decimal places.)
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 12% for all items sold.
Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year. The statement follows:
Explanation / Answer
Before proceeding with the solution, it is helpful first to restructure the data into contribution format for each of the three alternatives. (The data in the statements below are in thousands.) 12%Commission 17% Commission Own Sales Force Sales $17,800 100% $17,800 100% $17,800.00 100.00% Variable expenses: Manufacturing 7,500 7,500 7,500.00 Commissions (12%, 17%, 8.1%) 2,136 3,026 1,441.80 Total variable expenses 9,636 54.1% 10,526 59.1% 8,941.80 50.2% Contribution margin 8,164 45.9% 7,274 40.9% 8,858.2 49.8% Fixed expenses: Manufacturing overhead 2,580 2,580 2,580.00 Marketing 180 180 2,316.0 * Administrative 2,100 2,100 1,995.0 ** Interest 600 600 600 Total fixed expenses 5,460 5,460 7,491.00 Income before income taxes 2,704 1,814 1,367.2 Income taxes (35%) 946.4 634.9 478.52 Net income $1,757.60 $1,179.10 $888.68 *$180,000 + $2,136,000 = $2,316,000 **$2,100,000 - $105,000 = $1,995,000 1 When the income before taxes is zero, income taxes will also be zero and net income will be zero. Therefore, the break-even calculations can be based on the income before taxes. a Break-even point in dollar sales if the commission remains 12%: Dollar sales to break even = Fixed expenses ÷ CM ratio = $5,460,000 ÷ 0.459 = $11,895,425 b Break-even point in dollar sales if the commission increases to 20%: Dollar sales to break even = Fixed expenses ÷ CM ratio = $5,460,000 ÷ 0.409 = $13,349,633 c Break-even point in dollar sales if the company employs its own sales force: Dollar sales to break even = Fixed expenses ÷ CM ratio = $7,491,000 ÷ 0.498 = $15,042,169 2 In order to generate a $1,757,600 net income, the company must generate $2,704,000 in income before taxes. Therefore, Dollar sales to attain target = (Target income before taxes + Fixed expenses) ÷ CM ratio ($2,704,000+$5,460,000) ÷ 0.409 $8,164,000 ÷ 0.409 = $19,960,880 3 To determine the volume of sales at which net income would be equal under either the 17% commission plan or the company sales force plan, we find the volume of sales where costs before income taxes under the two plans are equal. See below X = Total sales revenue 0.591X + $5,460,000 = 0.502X + $7,491,000 0.089X = $2,031,000 X = $2,031,000 ÷ 0.089 X = $22,820,225 Thus, at a sales level of $22,820,225 either plan would yield the same income before taxes and net income. Below this sales level, the commission plan would yield the largest net income; above this sales level, the sales force plan would yield the largest net income. 4 a., b., and c. 12% Commission 17% Commission Own Sales Force Contribution margin (Part 1) (x) $ 8,164,000 $ 7,274,000 $ 8,858,200 Income before taxes (Part 1) (y) $ 2,704,000 $ 1,814,000 $ 1,367,200 Degree of operating leverage: (X) ÷ (Y) 3.02 4.01 6.48