Chapter 5, Problem 33C

To determine

Break-Even Point:

A break-even point is the point where a company is neither making profit nor incurring any loss.

Target Profit Analysis:

It is an analysis of how much unit sales or dollar sales value a company must attain to realize the target profit estimated by the company.

Degree of operating leverage:

A degree of operating leverage shows the impact of operating leverage on the operating income of a company.

1. Pittman Company’s break-even point in dollar sales

a. The agents’ commission rate remains unchanged at 15%.

b. The agents’ commission rate is increased to 20%

c. The company employs its own sales force.

2.The required sales in dollars to generate same net income if the company pays the 20% commission rate.

3. The required sales in dollars to generate same net income regardless of whether company sells through agents or employs its own sales force.

4. The degree of operating leverage

a. The agents’ commission rate remains unchanged at 15%.

b. The agents’ commission rate is increased to 20%

c. The company employs its own sales force.

5. Recommendation to make a decision.

Answer to Problem 33C

Solution:

1. Pittman Company’s break-even point in dollar sales

a. The agents’ commission rate remains unchanged at 15% is $12,000,000.

b. The agents’ commission rate is increased to 20% is $13,714,285.7.

c. The company employs its own sales force is $15,000,000.

2. The required sales in dollars to generate same net income if the company pays the 20% commission rate is $18,285,714.

3. At $18,600,000 of sales, the company will generate same amount of net income regardless of whether it sells through agents or employs its own sales force.

4. The degree of operating leverage

a. The degree of operating leverage at 15% is 4.

b. The degree of operating leverage at 20% is 7.

c. If the company employs its own sales force, the degree of operating leverage will be 16.

5. It is recommended that the company should continue using the sales agents at 20% commission rate as it provides a better net income, break-even point and degree operating leverage.

Explanation of Solution

1. Compute Pittman Company’s break-even point in dollar sales for next year assuming;

$$ $Break-evenpointindollarsales=\frac{Fixedexpenses}{Contributionmarginratio}$

a. The agents’ commission rate remains unchanged at 15%

  $\begin{array}{l} Break-evenpointindollarsales=\frac{\$4,800,000}{0.40}\hfill \\ = \$12,000,000 \hfill \end{array}$

b. The agents’ commission rate is increased to 20%

  $\begin{array}{l} Break-evenpointindollarsales=\frac{\$4,800,000}{0.35}\hfill \\ = \$13,714,286 \hfill \end{array}$

c. The company employs its own sales force.

  $\begin{array}{l} Break-evenpointindollarsales=\frac{\$7,125,000}{0.475}\hfill \\ = \$15,000,000 \hfill \end{array}$

2. Computation of required sales in dollars to acquire a target profit of $1,600,000 if the company pays 20% commission rate.

  $\begin{array}{l}Requiredsalesindollars=\frac{Fixedexpenses+Targetprofit}{Contributionmarginratio}\hfill \\ =\frac{\$4,800,000+\$1,600,000}{0.35}\hfill \\ =\$18,285,714\hfill \end{array}$$$

3. Computation of dollar sales where net income will be equal whether company sells through 20% commission rate or employs own sales force.

Assume the sales volume is X.

  $\begin{array}{l}\begin{array}{l}So,X*65\%+\$4,800,000=X*52.5+\$7,125,000\hfill \\ 0.65X–0.525X=\$7,125,000+\$4,800,000\hfill \\ 0.125X=\$2,325,000\hfill \\ X=\$2,325,000/0.125\hfill \end{array} \\ X=\$18,600,000\end{array}$

4. Computation of degree of operating leverage

  $Degreeofoperatingleverage=\frac{Contributionmargin}{Netincomebeforetax}$

a. The agents’ commission rate remains unchanged at 15%.

  $\begin{array}{l}Degreeofoperatingleverage=\frac{\$6,400,000}{\$1,600,000}\hfill \\ =4\hfill \end{array}$

b. The agents’ commission rate is increased to 20%

  $\begin{array}{l}Degreeofoperatingleverage=\frac{\$5,600,000}{\$800,000}\hfill \\ =7\hfill \end{array}$

c. The company employs its own sales force.

  $\begin{array}{l}Degreeofoperatingleverage=\frac{\$7,600,000}{\$475,000}\hfill \\ =16\hfill \end{array}$

Pittman Company Contribution Format Income Statement For the Year Ended December 31
	15% Agents Commission		20% Agents Commission		Owns Sales Force
Sales	$16,000,000	100%	$16,000,000	100%	$16,000,000	100%
Variable expenses:
Manufacturing expenses	$7,200,000		$7,200,000		$7,200,000
Commissions to agents	$2,400,000		$3,200,000		$1,200,000
Total variable expenses	$9,600,000	60%	$10,400,000	65%	$8,400,000	52.5%
Contribution margins	$6,400,000	40%	$5,600,000	35%	$7,600,000	47.5%
Fixed expenses:
Manufacturing overheads	$2,340,000		$2,340,000		$2,340,000
Marketing expenses	$120,000		$120,000		$2,520,000
Administrative expenses	$1,800,000		$1,800,000		$1,725,000
Interest expenses	$540,000		$540,000		$540,000
Total fixed expenses	$4,800,000		$4,800,000		$7,125,000
Income before tax	$1,600,000		$800,000		$475,000
Income tax (30%)	$480,000		$240,000		$142,500
Net income	$1,120,000		$560,000		$332,500

Conclusion

It is concluded that Pittman Company should stick with sales agents at 20% commission rate because the decrease in the sales decrease in commission to 7.5% and the administrative expenses by $75,000 is actually less than the increase of fixed expenses of $2,400,000 which results in decreased net income before tax. A break-even point is technique used the companies to predict the outcome of a decision based on the analysis. It shows the exact point where a company will neither make profit nor suffer loss. The lower the break-even point, a company is more likely to make more profits and the higher the break-even point, a company is at high risk of incurring loss.