4. Pittman Company is a small but growing manufacturer of telecommunications equ
ID: 2428220 • Letter: 4
Question
4. 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 commission of 15% of selling price 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' 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 costs would increase by $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% × $16,000,000) that we would avoid on agents' commissions.”
The breakdown of the $2,400,000 cost follows:
“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'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.”
Required:
1. Compute Pittman Company's break-even point in sales dollars 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 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 Pitt-man 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 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.
Explanation / Answer
1.
A. The break-even point is $12,000,000
B. The break-even point is $13,714,286
C.The break-even point is $15,157,895
2 If the company wanted to generate the same net income as contained in the budgeted income statement while paying a commission of 20% they would have to have sales totaling $17,142,857.
Pittman Company
Contribution Income statement
For the month of
Total
Cm Ratio
Sales
$17,142,857
100%
Less: Variable expense
$11,142,857
65%
Contribution margins
$6,000,000
35%
Less: Fixed cost
$4,800,000
Net operating income
$1,200,000
3 If the company wanted to generate the same net income as contained in the budgeted income statement, while paying no commission and hire no sales force, they would have to generate sales of $10,909,091 to generate a profit of $1,200,000.
Pittman Company
Contribution Income statement
For the month of
Total
Cm Ratio
Sales
$10,909,091
100%
Less: Variable expense
$4,909,091
45%
Contribution margins
$6,000,000
55%
Less: Fixed cost
$4,800,000
Net operating income
$1,200,000
4.
A. Operating leverage is 4
B Operating leverage is 7
C. Operating leverage is 19
5 If the company decides to stay the course and continue to pay a commission of 15% this will allow them to operate with the lowest possible break even point. While a 20% commission will put the break-even point at the highest level of the three scenarios. However if the company decides to stay the course they will have a relatively low operating leverage and will need a substantial increase in sales to increase profit. The best choice is for the company to drop the outside sales force and hire an internal sales team. An internal sales team would have a break-even point higher than the status quo but lower than with a 20% increase in sales commission. Also another key selling point for hiring an internal sales team is that operating leverage will significantly increase. There by suggesting that with a slight increase in sales profits would greatly increase and the additional fixed cost would be justified by significantly higher profits.
Pittman Company
Contribution Income statement
For the month of
Total
Cm Ratio
Sales
$17,142,857
100%
Less: Variable expense
$11,142,857
65%
Contribution margins
$6,000,000
35%
Less: Fixed cost
$4,800,000
Net operating income
$1,200,000
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