Pitman Company is small but growing manufacturer of telecommunications equipment
ID: 2756612 • 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. Compute Pitman Company’s break-even point in sales dollars for the 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 Pitman Company decides to continue selling through agents and pays the 20% 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.
3. 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.
4. Compute the degree of operating leverage that the company would expected to have on December 31 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.
5. Based on the data in (1) through (4) above, make a recommendation as to whether the company should continue to use sales agents (at a 20% commission rate) or employ its own sales force. Give the reasons for your answer.
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
Answer:
* $120,000 + $2,400,000 = $2,520,000 ** $1,800,000 - $75,000 = $1,725,000
Answer:1
a BEP=Fixed expenses/CM ratio =$4800000/0.40=$12000000
b. BEP=Fixed expenses/CM ratio =$4800000/0.35=$13,714,286
c.BEP=Fixed expenses/CM ratio =$7125000/0.475=$1500000
Answer:2 To generate the same net income of $1,120,000, the company must generate $1,600,000 in income before taxes (assuming a 30% effective tax rate). Therefore, with an increase in the commission rate to 20 percent, the targeted sales volume would be:
Fixed Costs/CM ratio + Targeted Income Before Taxes = Targeted Sales
$4,800,000/0.35 + $1,600,000 = $18,285,714 Targeted Sales
Answer:3 To determine the volume of sales at which net income would be equal under either the 20 percent commission plan or the company sales force plan, the two cost structures are set equal to each other. Net income will be equal at that volume of sales where costs under the two plans are equal:
Let X = Total Sales Volume
Costs (20% Commission) = Costs (Sales Force Plan)
.65X + $4,800,000 = .525X + $7,125,000
.125X = $2,325,000
X = $18,600,000
Thus, at a sales level of $18,600,000 either plan would yield the same 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.
Answer:4
a. Degree of operating leverage=Contribution/EBIT
=6400,000/2140000=2.99
b.Degree of operating leverage=Contribution/EBIT
=5600,000/1340000=4.18
c. Degree of operating leverage=Contribution/EBIT
=7600,000/1015000=7.49
Answer:5 We would continue to use the sales agents for at least one more year, and possibly for two
more years. The reasons are as follows:
First, use of the sales agents would have a less dramatic effect on net income.
Second, use of the sales agents for at least one more year would give the company more time to hire competent people and get the sales group organized.
Third, the sales force plan doesn’t become more desirable than the use of sales agents until the company reaches sales of $18,600,000 a year. This level probably won’t be reached for at least one more year, and possibly two years.
Fourth, the sales force plan will be highly leveraged since it will greatly increase fixed costs (and decrease variable costs). One or two years from now, when sales have reached the $18,600,000 level, the company can benefit greatly from this leverage. For the moment, profits will be greater and risks will be less by staying with the agents, even at the higher 20% commission rate.
in 000 Particulars 15% Comm 20% Comm Own force Sales 16000 100% 16000 100% 16000 100% Less variable expenses: Manufacturing 7200 7200 7200 comm(15%,20%,7.5%) 2400 3200 1200 Total variable exp 9600 60% 10400 65% 8400 52.50% Contribution margin 6400 40% 5600 35% 7600 47.500% Less fixed expenses: Manufacturing overhead 2340 2340 2340 Marketing 120 120 2520 * Administrative 1800 1800 1725 ** Interest 540 540 540 Total fixed expenses 4800 4800 7125 Income before income taxes 1600 800 475 Less income taxes (30%) 480 240 142.5 Net income 1120 560 332.5