Cellular 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.

Santa Monica, Cellulars controller, has just prepared the companys budgeted income statement for next year as follows:

CELLULAR COMPANY

Budgeted Income Statement

For the Year Ended December 31

Sales $16,000,000

Manufacturing expenses:

Variable..$7,200,000

Fixed.. 2,300,000 9,500,000

Gross margin.. $6,500,000

Selling and administrative expenses:

Sales commissions.$2,400,000

Fixed marketing expenses. 100,000

Fixed administrative expenses 1,800,000 4,300,000

Operating income.. $2,200,000

Interest expense.. 600,000

Income before income taxes $1,600,000

Income taxes (30%) 480,000

Net income.. $1,120,000

Note: Depreciation on storage facilities

As Santa Monica handed the statement to Vincent Kompany, Cellulars president, he commented, I went ahead and used the agents 15% commission rate in completing these statements, but we have just learned that they refused to handle our products next year unless we use the commission rate to 20%.

Thats the last straw, Vincent replied angrily. Those agents have been demanding more and more, and this time they have 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, there is nothing left over for profit, replied Sana Monica.

Vincent echoed Santa Monicas statement and proposed to have their own sales force. Vincent asks Santa Monica to work up some cost figures to look at. Sana Monica did some research and identified several companies paying about a 7.5% commission to their own salespeople, along with a small salary. Santa Monica figured that fixed cost 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.

Check the break down of the $2,400,000 cost below:

Salaries:

Sales manager.. $ 100,000

Salespersons. 600,000

Travel and entertainment .. 400,000

Advertising .. 1,300,000

TOTAL $2,400,000

Great, replied Vincent Kompany. And I noticed that $2,400,000 equals what we are paying the agents under the old 15% commission rate.

Its even better Santa Monica explained. We can actually save $75,000 a year because thats what we are paying to our auditors to check out the agents reports. So, our overall administrative expenses would be less.

Required:

Compute Cellular Companys break even point in dollars for next year assuming: A)The agents commission rate remains unchanged at 15%.

B)The company employees its own sales force.

2. Determine dollar sales at which net income would be equal regardless of whether Cellular Company sells through agents (at a 20% commission rate) or employees its own sales force.

3. Based on the data in (1) through (2) above, make a recommendation as to whether the company should continue to use sales agents (at a 20% commission rate) or employee its own sales force.

Give reasons for your answer.