Pitman Company is 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% selling price for all items sold.

Barbara Cheney, Pitman controller, has just prepared the companys budgeted income statement for next year. The statement follows:

Pitman Company Budgeted Income Statement For the Year Ended December 31
Sales		$16,000,000
Manufacturing costs:
Variable	7,200,000
Fixed overhead..	2,340,000	9,540,000
Gross margin		6,460,000
Selling and administrative costs:
Commissions to agents.	2,400,000
Fixed marketing costs	120,000
Fixed administrative costs..	1,800,000	4,320,000
Net operating income..		2,140,000
Fixed interest cost..		540,000
Income before income taxes..		1,600,000
Income taxes (30%)		480,000
Net income..		1,120,000
*primarily depreciation on storage facilities.

As Barbara handed the statement to Karl Vecci, Pitmans president, she commented, I want ahead and used the agents 15% commission rate in completing these statements, but weve just learned that they refuse to handle our products next year unless we increase the commission rate to 20%.

that the last straw, Karl replied angrily. Those agents have been demanding more and more, and this time theyve 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, theres nothing left over for profit, replied Barbara.

I say its just plain robbery, reported Karl. And I also 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 Barbara. Several companies we know about pay a 7.5% commission to their own salespeople, along with a small salary. Of course, we could have to handle would be more than offset by the $3,200,000 (20% x $1,600,000) that we would avoid on agents commission.

The breakdown of the $2,400,000 cost follows:

Salaries:
Sales managers..	$ 100,000
Sales persons..	600,000
Travel and entertainment..	400,000
Advertising.	1,300,000
Total.	2,400,000

Super, replied Karl. And I noticed that the $2,400,000 is just what were paying the agents under the old 15% commission rate.

Its even better than that, explained Barbara. We can actually save $75,000 a year because thats what we have to pay the auditing firm now to check out the agents reports. So our overall administrative costs would be less.

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

1. You should prepare variable costing income statements for each of the three alternatives. Also calculate the variable cost ratio and the contribution margin ratio for each alternative.

Then calculate breakeven points in dollar sales for each alternative. If income is zero, taxes are zero, so base the breakeven point on income before taxes.

2. To generate $1,120,000 of net income, they have to generate $1,600,000 in income before tax. Note that fixed expenses add up to $4,800,000.

3. Determine the volume of sales at which net income would be equal under either the 20% commission plan or the company sales force plan., which would be solving for X in the equation

.65X + $4,800,000 = .525X + 7,125,000.

4. Calculate the leverage for the three options.

5. Make a recommendation as to what you would advise the company to do.

Consider the following:

Should they keep the sales agents and still pay the 20%? This would give them more time to hire salespeople and develop a sales group.

Should they consider leverage in the decision, if they have their own sales force which means leverage will be high due to the fixed costs, if they think sales will increase that would provide them with higher income with a change in sales volume.

When do the sales force plan become better that the use of sales agents in terms of level of sales? (Indifferent point calculated in 3, above.) When will they reach that point?

Which option is more risky? What do you decide?