Cost Structure – Break-Even and Target Profit Analysis

First    –    answer the case study    2-32    in McGraw Hill Connect.    Then,    use the correct answers to write the case study report.    The actual case study in McGraw Hill Connect is worth    10    points. The remainder of the 50 points comes from your report. 

Answer each question as if you were a consultant hired by the company and are presenting to the president.

For each answer explain the terminology and concepts used. For example, in #1 rather than just give the breakeven for each scenario, explain the change in the volume of sales, explain the calculation – this is a professional report from a consultant to an executive committee. 

Use outside sources when necessary BUT MAKE SURE YOU CITE THEM!  

When giving a recommendation, back it up with numbers. 

This particular answer should be an executive committee report that is no more than 4 pages in length.

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 15% for all items sold.

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

Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales		$ 22,000,000
Manufacturing expenses:
Variable	$ 9,900,000
Fixed overhead	3,080,000	12,980,000
Gross margin		9,020,000
Selling and administrative expenses:
Commissions to agents	3,300,000
Fixed marketing expenses	154,000*Footnote asterisk
Fixed administrative expenses	2,040,000	5,494,000
Net operating income		3,526,000
Fixed interest expenses		770,000
Income before income taxes		2,756,000
Income taxes (30%)		826,800
Net income		$ 1,929,200

*Footnote asteriskPrimarily depreciation on storage facilities.

As Barbara handed the statement to Karl Vecci, Pittman’s president, she commented, “I went ahead and used the agents’ 15% 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 20%.”

“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 20% 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 7.5% 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 $3,300,000 per year, but that would be more than offset by the $4,400,000 (20% × $22,000,000) that we would avoid on agents’ commissions.”

The breakdown of the $3,300,000 cost follows:

Salaries:
Sales manager	$ 137,500
Salespersons	825,000
Travel and entertainment	550,000
Advertising	1,787,500
Total	$ 3,300,000

“Super,” replied Karl. “And I noticed that the $3,300,000 equals what we’re paying the agents under the old 15% commission rate.”

“It’s even better than that,” explained Barbara. “We can actually save $101,200 a year because that’s what we’re paying our auditors to check out the agents’ reports. So our overall administrative expenses 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.”

Required:

1. Compute Pittman Company’s break-even point in dollar sales for next year assuming:
   1. The agents’ commission rate remains unchanged at 15%.
   1. The agents’ commission rate is increased to 20%.
   1. The company employs its own sales force.
2. Assume that Pittman Company decides to continue selling through agents and pays the 20% commission rate. Determine the dollar sales that would be required to generate the same net income as contained in the budgeted income statement for next year.
3. Determine the dollar sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force.
4. Compute the degree of operating leverage that the company would expect to have at the end of next year assuming:
   1. The agents’ commission rate remains unchanged at 15%.
   1. The agents’ commission rate is increased to 20%.
   1. The company employs its own sales force.

Use income before income taxes in your operating leverage computation.