Gulf Industries, Inc. ("Gulf") is a small but growing manufacturer of medical products. 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 10% for all items sold.

Sarah Smith, Gulf's CFO, has just finished preparing the company's budget for the next fiscal year (20Y3), including the following budgeted income statement: Budgeted Income Statement, 20Y3

Sales revenue

$64,000,000

Cost of goods sold

Variable manufacturing costs

28,800,000

Fixed manufacturing costs

9,360,000

Gross profit

$25,840,000

Selling and administrative expenses

Sales commissions (10%)

6,400,000

Other selling expenses

480,000

Administrative expenses

7,200,000

Operating income

$11,760,000

Interest expense

2,160,000

Pre-tax income

$ 9,600,000

Income tax expense (25% rate)

2,400,000

Net income

$7,200,000

As Sarah handed the income statement to Jason Jones, Gulf's president, she commented, "I went ahead and used the agents' 10% commission rate in creating the budget, but we've just learned that they refuse to handle our products next year unless we increase the commission rate to 15%."

"That's the last straw," Jason replied angrily. "Those agents have been demanding more and more, and this time they've gone too far. How can they possibly defend a 15% commission

"They claim that after paying for advertising, travel, and the other promotional costs, there's nothing left over for profit," replied Sarah.

"I say it's just plain robbery," retorted Jason. "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 Sarah. "Several of our competitors employ their own sales force and pay them a straight salary rather than a commission. Of course, we would have to also handle all promotional costs, too. We figure our fixed expenses would increase by $10.5 million per year, but that would be offset by the $9.6 million of cost savings from not having to pay the agents a 15% commission on $64 million of sales."

The breakdown of the $10.5 million of fixed selling expenses is as follows:

Salary expenseSales staff

$ 3,400,000

Salary expenseSales manager

750,000

Advertising expenses

3,300,000

Travel and entertainment

1,700,000

Promotional costs (free samples etc.)

1,350,000

Total

$10,500,000

Required

Sarah has asked you to perform an analysis that she can distribute to Gulf's executive committee to help explain the financial implications of each of the following two options:

Option 1:Gulf agrees to increase the independent sales agents' commission rate to 15%.

Option 2:Gulf replaces the independent agents with its own in-house sales force.

The specific issues that Sarah would like you to address are listed below. You should also address these issues for the scenario where independent sales agents are paid a 10% commission so that Gulf's executive committee can compare Options 1 and 2 to the status quo.

1.Contribution margin income statements.In order to address Sarah's issues, you should first prepare pro-forma 20Y3 contribution margin income statements for Options 1 and 2, as well as the status quo. In all cases, assume that sales revenue equals the current budgeted sales of $64 million. Gulf's other selling expenses of $480,000, administrative expenses of $7.2 million, and interest expenses of $2.16 million are all fixed costs.

2.Sales revenue needed to break-even.What amount of sales revenue does Gulf need to generate in order to break-even? (Hint: Although the textbook formula for computing the break-even point does not explicitly take into account income taxes, you can still use that formula because income taxes are zero when profits are zero.)

3.Sales revenue needed to achieve target profit.What amount of sales revenue does Gulf need to generate in order to achieve its budgeted pre-tax income of $9.6 million?

4.Degree of operating leverage. What is Gulf's degree of operating leverage at the budgeted sales revenue of $64 million? Use pre-tax income as the denominator of the operating leverage fraction.

5.Profit if sales double. What is Gulf's projected pre-tax income if sales double from $64 million to $128 million?

6.Ranking of options.Rank Options 1 and 2 in terms of the projected 20Y3 profit, risk of loss (break-even sales), and profit if sales double.

7.Recommendation.Make a recommendation as to whether Gulf should insource the sales force, taking into account both the short-term and long-term consequences of this decision. Explain your recommendation in a paragraph or two and feel free to discuss any non-financial considerations that you believe are relevant.