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, Gulfs CFO, has just finished preparing the companys 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 & 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, Gulfs president, she commented, I went ahead and used the agents 10% commission rate in creating the budget, but weve just learned that they refuse to handle our products next year unless we increase the commission rate to 15%.

Thats the last straw, Jason replied angrily. Those agents have been demanding more and more, and this time theyve gone too far. How can they possibly defend a 15% commission rate?

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

I say its just plain robbery, retorted Jason. 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 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 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

Pull all of these numbers together and well show them to the executive committee tomorrow, said Jason. With the approval of the committee, we can move on the matter immediately.

Required

Sarah has asked you to perform an analysis that she can distribute to Gulfs 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 Gulfs executive committee can compare Options 1 and 2 to the status quo.

1. Contribution margin income statements. In order to address Sarahs issues, you should first prepare projected 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. Gulfs 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?

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 Gulfs 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 Gulfs projected pre-tax income if sales double from $64 million to $124 million?

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