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 sales commission of 20% for all items sold.

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 sales commission of 20% for all items sold.

Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year. The statement follows:

Pittman Company Budgeted Income Statement For the Year Ended December 31
Sales			$	20,200,000
Manufacturing expenses:
Variable	$	7,900,000
Fixed overhead		2,900,000		10,800,000
Gross margin				9,400,000
Selling and administrative expenses:
Commissions to agents		4,040,000
Fixed marketing expenses		260,000*
Fixed administrative expenses		2,500,000		6,800,000
Net operating income			$	2,600,000
Fixed interest expenses				680,000
Income before income taxes				1,920,000
Income taxes (25%)				480,000
Net income				1,440,000
*Primarily depreciation on storage facilities.

As Barbara handed the statement to Karl Vecci, Pittman’s president, she commented, “I went ahead and used the agents’ 20% 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 25%.”

“That’s the last straw,” Karl replied angrily. “Those agents have been demanding more and more, and this time they’ve gone too far. How can they possibly defend a 25% 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 Karl. “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 7.8% 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 expenses would increase by $4,040,000 per year, but that would be more than offset by the $5,050,000 (25% × $20,200,000) that we would avoid on agents’ commissions.”

The breakdown of the $4,040,000 cost follows:

  

Salaries:
Sales manager	$	240,000
Salespersons		1,300,000
Travel and entertainment		960,000
Advertising		1,540,000
Total	$	4,040,000

“Super,” replied Karl. “And I noticed that the $4,040,000 is just what we’re paying the agents under the old 20% commission rate.”

“It’s even better than that,” explained Barbara. “We can actually save $145,000 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 Karl. “With the approval of the committee, we can move on the matter immediately.” Explanation: The data in the statements below are in thousands.   20% Commission   25% Commission   Own Sales Force   Sales $ 20,200.00   100 %   $ 20,200.00   100 %   $ 20,200.00   100.0 %   Variable expenses:                                        Manufacturing   7,900.00           7,900.00           7,900.00            Commissions (20%, 25%, 7.8%)   4,040.00           5,050.00           1,575.60                                 Total variable expenses   11,940.00   59.1 %     12,950.00   64.1 %     9,475.60   46.9 %         Contribution margin   8,260.00   40.9 %     7,250.00   35.9 %     10,724.40   53.1 %         Fixed expenses:                                        Manufacturing overhead   2,900.00           2,900.00           2,900.00            Marketing   260.00           260.00           4,300.00 *          Administrative   2,500.00           2,500.00           2,355.00 **          Interest   680.00           680.00           680.00                           Total fixed expenses   6,340.00           6,340.00           10,235.00                           Income before income taxes   1,920.00           910.00           489.40         Income taxes (30%)   480.00           227.50           122.35                           Net income $ 1,440.00         $ 682.50         $ 367.05                         *$260,000 + $4,040,000 = $4,300,000 **$2,500,000 − $145,000 = $2,355,000 1. When the income before taxes is zero, income taxes will also be zero and net income will be zero. Therefore, the break-even calculations can be based on the income before taxes. a. Break-even point in dollar sales if the commission remains 20%:   Dollar sales to break even = Fixed expenses = $6,340,000  = $15,501,222 CM ratio 0.409 b. Break-even point in dollar sales if the commission increases to 25%: Dollar sales to break even = Fixed expenses = $6,340,000  = $17,660,167 CM ratio 0.359       c. Break-even point in dollar sales if the company employs its own sales force: Dollar sales to break even = Fixed expenses = $10,235,000  = $19,274,953 CM ratio 0.531   2. In order to generate a $1,440,000 net income, the company must generate $1,920,000 in income before taxes. Therefore, Dollar sales to attain target = Target income before taxes + Fixed expenses CM ratio     = $1,920,000 + $6,340,000   0.359   = $8,260,000  = $23,008,357 0.359    3. To determine the volume of sales at which net income would be equal under either the 25% commission plan or the company sales force plan, we find the volume of sales where costs before income taxes under the two plans are equal.   X = Total sales revenue 0.641X + $6,340,000 = 0.469X + $10,235,000    0.172X = $3,895,000 X = $3,895,000 ÷ 0.172   X = $22,645,349 Thus, at a sales level of $22,645,349 either plan would yield the same income before taxes and net income. Below this sales level, the commission plan would yield the largest net income; above this sales level, the sales force plan would yield the largest net income. 4. a., b., and c.   20% Commission 25% Commission Own Sales Force   Contribution margin (Part 1) (a) $ 8,260,000   $ 7,250,000   $ 10,724,400     Income before taxes (Part 1) (b) $ 1,920,000   $ 910,000   $ 489,400     Degree of operating leverage: (a) ÷ (b)   4.30     7.97     21.91