Pitman Company is small but growing manufacturer of telecommunications equipment
ID: 2756599 • Letter: P
Question
Pitman Company is 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 commission of 15% selling price for all items sold.
Barbara Cheney, Pitman’ controller, has just prepared the company’s budgeted income statement for next year. The statement follows:
Pitman Company
Budgeted Income Statement
For the Year Ended December 31
Sales……………………………………………………………………………………
$16,000,000
Manufacturing costs:
Variable………………………………………………………………………
7,200,000
Fixed overhead…………………………………………………………..
2,340,000
9,540,000
Gross margin………………………………………………………………………
6,460,000
Selling and administrative costs:
Commissions to agents……………………………………………….
2,400,000
Fixed marketing costs…………………………………………………
120,000
Fixed administrative costs…………………………………………..
1,800,000
4,320,000
Net operating income………………………………………………………..
2,140,000
Fixed interest cost……………………………………………………………..
540,000
Income before income taxes……………………………………………..
1,600,000
Income taxes (30%)……………………………………………………………
480,000
Net income………………………………………………………………………..
1,120,000
*primarily depreciation on storage facilities.
As Barbara handed the statement to Karl Vecci, Pitman’s president, she commented, “I want 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 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”, reported Karl. “And I also 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 could have to handle would be more than offset by the $3,200,000 (20% x $1,600,000) that we would avoid on agents commission.”
The breakdown of the $2,400,000 cost follows:
Salaries:
Sales managers…………………………………..
$ 100,000
Sales persons……………………………………..
600,000
Travel and entertainment………………………..
400,000
Advertising……………………………………………….
1,300,000
Total………………………………………………………….
2,400,000
“Super”, replied Karl. “And I noticed that the $2,400,000 is just what we’re paying the agents under the old 15% commission rate.”
“It’s even better than that,“ explained Barbara. “We can actually save $75,000 a year because that’s what we have to pay the auditing firm now to check out the agents reports. So our overall administrative costs would be less.”
“Put 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. Determine the volume of sales at which net income would be equal regardless of whether Pitman Company sells through agents (at a 20% commission rate) or employs its own sales force.
Pitman Company
Budgeted Income Statement
For the Year Ended December 31
Sales……………………………………………………………………………………
$16,000,000
Manufacturing costs:
Variable………………………………………………………………………
7,200,000
Fixed overhead…………………………………………………………..
2,340,000
9,540,000
Gross margin………………………………………………………………………
6,460,000
Selling and administrative costs:
Commissions to agents……………………………………………….
2,400,000
Fixed marketing costs…………………………………………………
120,000
Fixed administrative costs…………………………………………..
1,800,000
4,320,000
Net operating income………………………………………………………..
2,140,000
Fixed interest cost……………………………………………………………..
540,000
Income before income taxes……………………………………………..
1,600,000
Income taxes (30%)……………………………………………………………
480,000
Net income………………………………………………………………………..
1,120,000
*primarily depreciation on storage facilities.
Explanation / Answer
Net Income at a commission of 20% to sales commission agents Net Income at a commission of 7.5% to its own sales people Sales…………………………………………………………………………………… 1,60,00,000.00 Sales…………………………………………………………………………………… 1,60,00,000.00 Manufacturing costs: Manufacturing costs: Variable……………………………………………………………………… 72,00,000.00 Variable……………………………………………………………………… 72,00,000.00 Fixed overhead………………………………………………………….. 23,40,000.00 95,40,000.00 Fixed overhead………………………………………………………….. 23,40,000.00 95,40,000.00 Gross margin……………………………………………………………………… 64,60,000.00 Gross margin……………………………………………………………………… 64,60,000.00 Selling and administrative costs: Selling and administrative costs: Commissions to agents………………………………………………. 32,00,000.00 Commissions to agents………………………………………………. 12,00,000.00 Fixed marketing costs………………………………………………… 1,20,000.00 Fixed marketing costs………………………………………………… 1,20,000.00 Fixed administrative costs…………………… ** 18,00,000.00 51,20,000.00 Fixed administrative costs………………………………………….. 17,25,000.00 30,45,000.00 1,800,000 less 75,000 of Audit Fees Net operating income……………………………………………………….. 13,40,000.00 Net operating income……………………………………………………….. 34,15,000.00 Fixed interest cost…………………………………………………………….. 5,40,000.00 Fixed interest cost…………………………………………………………….. 5,40,000.00 Income before income taxes…………………………………………….. 8,00,000.00 Income before income taxes…………………………………………….. 28,75,000.00 Income taxes (30%)…………………………………………………………… 2,40,000.00 Income taxes (30%)…………………………………………………………… 8,62,500.00 Net income……………………………………………………………………….. 5,60,000.00 Net income……………………………………………………………………….. 20,12,500.00 **primarily depreciation on storage facilities. *primarily depreciation on storage facilities. The net income in the two scenarios should be equal. Hence, in order to obtain a net income of 20,12,500 in the scenario of 20% commission to sales commission agents, the sales value would be $ 57,500,000.