CASE 3-33 Cost Structure; Break-Even and Target Profit Analysis [LO34, LO35, LO36]

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, Pittmans controller, has just prepared the companys budgeted income statement for next year. The statement follows:

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales. . . . . . . . . . . . . . . . . . .		$16,000,000
Manufacturing expenses:
Variable. . . . . . . . . . . . . . . . . . . . .	$7,200,000
Fixed overhead. . . . . . . . . . . . . . .	2,340,000	9,540,000
Gross margin. . . . . . . . . . . . . . . . .		6,460,000
Selling and administrative expenses:
Commissions to agents. . . . . . . . . . . . . . .	2,400,000
Fixed marketing expenses. . . . . . . . . . . .	1,20,000*
Fixed administrative expenses. . . . . . .	1,800,000	4,320,000
Net operating income . . . . . . . . . . . . . .		2,140,000
Fixed interest expenses . . . . . . . . . . .		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, Pittmans president, she commented, I went ahead and used the agents 15% commission rate in completing these statements, but weve just learned that they refuse to handle our products next year unless we increase the commission rate to 20%.

Thats the last straw, Karl replied angrily. Those agents have been demanding more and more, and this time theyve 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, theres nothing left over for profit, replied Barbara.

I say its just plain robbery, retorted Karl. And I also say its 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?

Weve 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 $2,400,000 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:

Salaries:
Sales manager. . . . . . . . . . . . . . . .	$ 100,000
Salespersons. . . . . . . . . . . . . . . .	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 were paying the agents under the old 15% commission rate.

Its even better than that, explained Barbara. We can actually save $75,000 a year because thats what were having to pay the auditing firm now to check out the agents reports. So our overall administrative expenses would be less.

Pull all of these numbers together and well 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 Companys 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 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.

5. Based on the data in requirements 1-4 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 reasons for your answer.