CASE 533 Cost Structure; Break-Even and Target Profit Analysis LO54, LO55, LO56

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 as 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 120,000* 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.

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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 equals 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 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.

4. Compute the degree of operating leverage that the company would expect to have at the end of next year assuming:

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