Question

Case 5-33 Cost Structure; Break-Even and Target Profit Analysis

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				$	17,000,000
Manufacturing expenses:
Variable	$	7,650,000
Fixed overhead		2,380,000			10,030,000
Gross margin					6,970,000
Selling and administrative expenses:
Commissions to agents		2,550,000
Fixed marketing expenses		119,000	*
Fixed administrative expenses		1,840,000			4,509,000
Net operating income					2,461,000
Fixed interest expenses					595,000
Income before income taxes					1,866,000
Income taxes (30%)					559,800
Net income				$	1,306,200

*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 $2,550,000 per year, but that would be more than offset by the $3,400,000 (20% × $17,000,000) that we would avoid on agents’ commissions.”

The breakdown of the $2,550,000 cost follows:

Salaries:
Sales manager	$	106,250
Salespersons		637,500
Travel and entertainment		425,000
Advertising		1,381,250
Total	$	2,550,000

“Super,” replied Karl. “And I noticed that the $2,550,000 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 $78,200 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

The data in the statements below are in thousands.

	15% Commission						20% Commission						Own Sales Force
Sales	$	17000		100	%		$	17000		100	%		$	17000		100.0	%
Variable expenses:
Manufacturing		7650						7650						7650
Commissions (15%, 20%, 7.5%)		2550						3400						1275
Total variable expenses		10200		60.0	%			11050		65.0	%			8925		52.5	%
Contribution margin		6800		40.0	%			5950		35.0	%			8075		47.5	%
Fixed expenses:
Manufacturing overhead		2380						2380						2380
Marketing		119						119						2669
Administrative		1840						1840						1761.80
Interest		595						595						595
Total fixed expenses		4934						4934						7405.80
Income before income taxes		1866						1016						669.20
Income taxes (30%)		559.80						304.80						200.76
Net income	$	1306.20					$	711.20					$	468.44

119000+2550000 = 2520000 1840000-78200 = 1761800

Part 1 A

Dollar sales to break even= fixed expenses/CM ratio = 4934000/0.400 = $12335000

Part 1 B

Dollar sales to break even= fixed expenses/CM ratio = 4934000/0.350 = $14097143

Part 1 C

Dollar sales to break even= fixed expenses/CM ratio = 7405800/0.475 = $15591158

Part 2

In order to generate a $1306200 net income, the company must generate $1866000 in income before taxes

Dollar sales to attain target= target income before taxes + fixed expenses / contribution margin ratio = (1866000+4934000)/ 0.350 = $19428571

Part 3

X = total sales revenue

0.650x+4934000 = 0.525x+7405800

0.125x =2471800

X = $19774400

Part 4

	15% Commission	20% Commission	Own Sales Force
Contribution margin (Part 1) (a)	6800000	5950000	8075000
Income before taxes (Part 1) (b)	1866000	1016000	669200
Degree of operating leverage: (a) ÷ (b)	3.64	5.86	12.07