Case 5-32 (Algo) Cost Structure; Break-Even and Target Profit Analysis [LO5-4, LO5-6, LO5-7]

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, Pittmans controller, just prepared the companys budgeted income statement for next year as follows:

Pittman CompanyBudgeted Income StatementFor the Year Ended December 31Sales$ 24,500,000Manufacturing expenses:Variable$ 11,025,000Fixed overhead3,430,00014,455,000Gross margin10,045,000Selling and administrative expenses:Commissions to agents3,675,000Fixed marketing expenses171,500*Fixed administrative expenses2,140,0005,986,500Net operating income4,058,500Fixed interest expenses857,500Income before income taxes3,201,000Income taxes (30%)960,300Net income$ 2,240,700

*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 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 after paying for advertising, travel, and the other costs of promotion, theres nothing left over for profit, replied Barbara.

Thats ridiculous, 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 of 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 $3,675,000 per year, but that would be more than offset by the $4,900,000 (20% $24,500,000) we would avoid on agents commissions.

The breakdown of the $3,675,000 cost follows:

Salaries:Sales manager$ 153,125Salespersons918,750Travel and entertainment612,500Advertising1,990,625Total$ 3,675,000

Super, replied Karl. And I noticed the $3,675,000 equals what were paying the agents under the old 15% commission rate.

Its even better than that, explained Barbara. We can actually save $112,700 a year because thats what were paying our auditors 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:

Compute Pittman Companys break-even point in dollar sales for next year assuming:

1. The agents commission rate remains unchanged at 15%.
2. The agents commission rate is increased to 20%.
3. The company employs its own sales force.
4. Assume Pittman Company decides to continue selling through agents and pays the 20% commission rate. Calculate the dollar sales required to generate the same net income as contained in the budgeted income statement for next year.
5. 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 haveat the end of next yearassuming:

1. The agents commission rate remains unchanged at 15%.
2. The agents commission rate is increased to 20%.
3. The company employs its own sales force.

Use income before income taxes in your operating leverage computation.