Farah, the owner of a used car dealership, is working on compensation plans for her employees. She is trying to evaluate how a commission-based versus salary-based workforce would affect her bottom line. In considering her options, she finds basic financial information of two companies with similar year-end performance but different compensation plans—perfect examples to help her with her evaluation! Company X uses a commission-based approach, where its sales staff operates exclusively on
commission. Company Y, on the other hand, pays its sales staff a flat salary with no commission.
Here are the basics for each company.
Company X Company Y
Current sales volume 10,000 units 10,000 units
Selling price $50 $50
Variable cost per unit $20 $10
Fixed costs $100,000 $200,000
Required
a. Present a contribution margin income statement for each company at its current volume of sales and calculate the degree of operating leverage (DOL) for each.
b. Utilizing the DOL from part (a), calculate the percentage and dollar amount by which income will increase for each company if they both increase their sales by 30%.
c. Utilizing the DOL from part (a), calculate the percentage and dollar amount by which income will decrease for each company if they both decrease their sales by 30%.
d. Farah has used the DOL to make her projections in parts (b) and (c). Her advisory board,
however, is not as familiar with the concept; they want to see full income statements in order to believe that income really would increase (or decrease) by these amounts due to a change in volume. Help Farah present her analysis more clearly to the board by preparing contribution margin income statements for both companies, under both the volume increase and decrease scenarios in parts (b) and (c).
e. For which type(s) of business(es) do you think a low(er) degree of operating leverage would be preferable? What about a high(er) degree of operating leverage? Explain your responses to both of these questions.
f. How will this analysis help Maddie and her board make their decision on whether to create commission-based or salary-based compensation plans for their sales force?