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:

Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales $ 17,500,000
Manufacturing expenses:
Variable $ 7,875,000
Fixed overhead 2,450,000 10,325,000
Gross margin 7,175,000
Selling and administrative expenses:
Commissions to agents 2,625,000
Fixed marketing expenses 122,500*
Fixed administrative expenses 1,860,000 4,607,500
Net operating income 2,567,500
Fixed interest expenses 612,500
Income before income taxes 1,955,000
Income taxes (30%) 586,500
Net income $ 1,368,500
*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 $2,625,000 per year, but that would be more than offset by the $3,500,000 (20% × $17,500,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,625,000 cost follows:

Salaries:
Sales manager $ 109,375
Salespersons 656,250
Travel and entertainment 437,500
Advertising 1,421,875
Total $ 2,625,000

“Super,” replied Karl. “And I noticed that the $2,625,000 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 $80,500 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.

Answer 1

Answer: 1a. Break-even point assuming 15% commission rate:

Contribution margin per dollar of sales = Sales - Variable expenses = $17,500,000 - $7,875,000 = $9,625,000

Break-even point = Fixed expenses ÷ Contribution margin ratio

Contribution margin ratio = Contribution margin ÷ Sales = $9,625,000 ÷ $17,500,000 = 0.55

Break-even point = $4,607,500 ÷ 0.55 = $8,377,273

1b. Break-even point assuming 20% commission rate:

Contribution margin per dollar of sales = Sales - Variable expenses = $17,500,000 - $7,875,000 = $9,625,000

New commission rate = 20% of sales

New commission expense = 0.20 × $17,500,000 = $3,500,000

New contribution margin = $9,625,000 - $3,500,000 = $6,125,000

Break-even point = Fixed expenses ÷ Contribution margin ratio

Contribution margin ratio = Contribution margin ÷ Sales = $6,125,000 ÷ $17,500,000 = 0.35

Break-even point = $4,607,500 ÷ 0.35 = $13,164,286

1c. Break-even point assuming own sales force:

Contribution margin per dollar of sales = Sales - Variable expenses = $17,500,000 - $7,875,000 = $9,625,000

Fixed expenses increase by $2,625,000

The contribution margin decreases by $2,625,000 due to the elimination of agent commissions.

New contribution margin = $9,625,000 - $2,625,000 = $7,000,000

Break-even point = Fixed expenses ÷ Contribution margin ratio

Contribution margin ratio = Contribution margin ÷ Sales = $7,000,000 ÷ $17,500,000 = 0.40

Break-even point = ($4,607,500 + $2,625,000) ÷ 0.40 = $18,057,500

Sales required to generate the same net income as the budgeted income statement with 20% commission rate:

Net income = $1,368,500

Fixed expenses = $4,607,500 + $612,500 = $5,220,000

Contribution margin per dollar of sales = Sales - Variable expenses = $17,500,000 - (0.20 × $17,500,000) - $7,875,000 = $5,750,000

Required sales = (Fixed expenses + Net income) ÷ Contribution margin ratio

Contribution margin ratio = Contribution margin ÷ Sales = $5,750,000 ÷ $17,500,000 = 0.33

Required sales = ($5,220,000 + $1,368,500) ÷ 0.33 = $22,518,182

Sales at which net income would be equal regardless of sales method:

Net income = $1,368,500

Fixed expenses = $4,607,500 + $612,500 = $5,220,000

Contribution margin per dollar of sales for own sales force = $17,500,000 - $7,875,000 - $2,625,000 = $6,000,000

Contribution margin per dollar of sales for agents with 20% commission rate = $17,500,000 - (0.20 × $17,500,000) - $7,875

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%.

Contribution margin = Sales - Variable expenses

= $17,500,000 - $7,875,000

= $9,625,000

Contribution margin ratio = Contribution margin ÷ Sales

= $9,625,000 ÷ $17,500,000

= 0.55

Fixed expenses = $2,450,000 + $2,625,000 + $1,860,000 + $612,500

= $7,547,500

Operating income = Contribution margin - Fixed expenses

= $9,625,000 - $7,547,500

= $2,077,500

Degree of operating leverage = Contribution margin ÷ Operating income

= $9,625,000 ÷ $2,077,500

= 4.63

b. The agents’ commission rate is increased to 20%.

Contribution margin = Sales - Variable expenses

= $17,500,000 - $7,875,000

= $9,625,000

Fixed expenses = $2,450,000 + $3,500,000 + $1,860,000 + $612,500

= $8,422,500

Operating income = Contribution margin - Fixed expenses

= $9,625,000 - $8,422,500

= $1,202,500

Degree of operating leverage = Contribution margin ÷ Operating income

= $9,625,000 ÷ $1,202,500

= 7.99

c. The company employs its own sales force.

Contribution margin = Sales - Variable expenses

= $17,500,000 - $7,875,000

= $9,625,000

Fixed expenses = $2,450,000 + $2,625,000 + $109,375 + $656,250 + $437,500 + $1,421,875 + $80,500

= $7,780,750

Operating income = Contribution margin - Fixed expenses

= $9,625,000 - $7,780,750

= $1,844,250

Degree of operating leverage = Contribution margin ÷ Operating income

= $9,625,000 ÷ $1,844,250

= 5.22

Therefore, the degree of operating leverage would be 4.63, 7.99, and 5.22 if the agents' commission rate remains unchanged at 15%, is increased to 20%, and if the company employs its own sales force, respectively.

Explanation: