CASE 4-33 Cost Structure; Break-Even and Target Profit Analysis (LOL, LOS, L06) 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 stats- ment for next year. The statement follows: $16,000,000 9.540,000 6,460,000 Pittman Company Budgeted Income Statement For the Year Ended December 31 Sales Manufacturing expenses: Variable .. $7,200,000 Fored overhead ...... ... 2,340,000 Gross margin ...... Seling and administrative expenses: Commissions to agents .... 2,400,000 Fixed marketing expenses......... 120,000 Fixed administrative expenses .... 1,800,000 Net operating income.... Fixed interest expenses...... Income before income taxes .... Income taxes (30%). Not income 4,320,000 2,140,000 540,000 1,600,000 480,000 $ 1,120,000 "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?" 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 $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% X $16,000,000) that we would avoid on agents' commissions." Cost-Volume-Profit Relationships The breakdown of the $2,400,000 cost follows: Salaries: Sales manager ..... Salespersons ........ Travel and entertainment... Advertising .......... Total ......... $ 100,000 600,000 400,000 1,300,000 $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're having to pay the auditing firm now to check out the agents' reports. So our over- all administrative expenses would be less." "Pull all of these numbers together and we'll show them to the executive committee tomor- row," 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. 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 saine 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 Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force. 4 Compute the degree of ampute the degree of operating leverage that the company would expect to have on Decem- ber 31 at the end of next year assuming: 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. Ilse income before income taxes in your operating leverage computation. tin (1) through (4) above, make a recommendation as to whether the com- Based on the data in (1) through (4) ld continue to use sales agents (at a 20% commission rate) or employ its own sales force. Give reasons for your answer. pany should continue to (CMA, adapted)