Cost Structure; Target Profit and Break-Even Analysis 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 commission of 15% of selling price for all items sold. Barbara Cheney, Pittman's Vice President Controller, has just prepared the company's budgeted income statement for next year. The statement follows: As Barbara handed the statement to Karla 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," Karla 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 that after paying for advertising, travel, and the other costs of promotion, there's nothing left over for profit," replied Barbara. "I say it's just plain robbery," retorted Karla. "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 costs 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." The breakdown of the $2,400,000 cost follows: "Super," replied Karla. "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 overall administrative costs would be less." "Pull all of these numbers together and we'll show them to the executive committee tomorrow," said Karla. "With the approval of the committee, we can move on the matter immediately." Source: CMA (Certified Managerial Accountant) adapted Required: 1. Compute Pittman Company's break-even point in sales dollars for next year assuming: Use Template 1 for the analysis (8 points) The agents' commission rate remains unchanged at 15%. The agents' commission rate is increased to 20%. The company employs its own sales force. 2. 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 same net income as contained in the budgeted income statement for next year. Note: need to use the CM ratio % as the basis for the calculation. Need to show your work (3 points) 3. Determine the volume of sales at which net income would be equal regardless of whether Pitt-man Company sells through agents (at a 20% commission rate) or employs its own sales force. Note: create equation: 20% Sales commission; Profit = Own Sales Force; Profit refer to Template 1 data to create the two halves of the equation (3 points) 4. Compute the degree of operating leverage that the company would expect to have on December 31 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. 15% Commission 20% Commission Own Sales Force Contribution Margin Income Before Taxes Degree of operating Leverage Use income before income taxes in your operating leverage computation. (3 points) 5. Based on the data in (1) through (4) above, make a recommendation as to 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 referring to your previous analysis above. (4 points) 15% Commission 20% Commission Own Sales Force Sales .......................................... $16,000 100% $16,000 100% $16,000 100.0% Variable expenses: Manufacturing .......................... 7,200 7,200 7,200 Commissions (15%, 20% 7.5%) Total variable expenses................ _ % % % Contribution margin..................... % % % Fixed expenses: Manufacturing overhead............ 2,340 2,340 2,340 Marketing................................. 120 120 Administrative .......................... 1,800 1,800 Interest.................................... 540 540 540 Total fixed expenses .................... 4,800 4,800 Income before income taxes ........ 1,600 Income taxes (30%).................... Net income ................................. $1,120 $ $