Question

Pitman 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 commission of 15% of selling price for all items sold.Barbara Cheney, Pittman's controller, has just prepared the company's budgeted income statement for next year. The statement follows: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 costs would increase by 2,400,000 per year, but that would be more than offset by the 3,200,000(20% Ã 16,000,000) that we would avoid on agents' commissions."The breakdown of the 2,400,000 cost follows:"Super," replied Karl. "And I noticed that the 2,400,000 is just what we're paying the agents under the old 15 % commission rate.""It's even better than that," explained Barbara. "We can actually save 75,000 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'Il show them to the executive committee tomorrow," said Karl. "With the approval of the committee, we can move on the natter immediately"Required:Compute Pittman Company's break-even point in sales dollars for next year assuming:
(c) The company employs its own sales force.

Answer 1

Degree of operating leverage=Contribution/EBIT

=7600,000/1015000=7.49

We would continue to use the sales agents for at least one more year, and possibly for two

more years. The reasons are as follows:

First, the use of sales agents would have a less dramatic effect on operating leverage net income.

Second, the use of the sales agents for at least one more year would give the company more time to hire competent people and get the sales group organized.

Third, the sales force plan doesn’t become more desirable than the use of sales agents until the company reaches sales of $18,600,000 a year. This level probably won’t be reached for at least one more year, and possibly two years.

Fourth, the sales force plan will be higher operating leverage since it will greatly increase fixed costs (and decrease variable costs). One or two years from now, when sales have reached the $18,600,000 level, the company can benefit greatly from this leverage. For the moment, profits will be greater and risks will be less by staying with the agents, even at the higher 20% commission rate.

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