CASE $5-32$ Cost Structure; Break$-$Even and Target Profit Analysis LO$5-4,$ LO$5-6,$ LO$5-7$

Pittman Company is a small but growing manufacturer of telecommunications equipment.

The company has no sales force of its own; rather, it relies 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, just prepared the company's budgeted income state$-$

ment for next year as follows:

Pittman Company

Budgeted Income Statement

For the Year Ended December $31$

$\frac{?}{\text{b}\text{a}\text{r}}{(}^{*}$ Primarity $)$ 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 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 after paying for advertising, travel, and the other costs of promotion, there's noth$-$

ing left over for profit," replied Barbara.

"That's ridiculous," 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 of pay a $7\mathrm{.}5\%$

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)$ 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. "Super," replied Karl. "And I noticed the $$2,400,000$ 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 $$75,000$ 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 tomor$-$

row," said Karl. "With the approval of the committee, we can move on the matter immediately."

Required:

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 Pittman Company decides to continue selling through agents and pays the $20\%$ com$-$

mission rate. Calculate the dollar sales required to generate the same net income as contained

in the budgeted income statement for next year.

Calculate 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.

Compute the degree of operating leverage 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.

Based on the data in $(1)$ through $(4)$ above, make a recommendation 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.