Managerial Accounting for Managers Case 4-33

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Textbook case:
Managerial Accounting for Managers, 2nd edition Noreen, Brewer and Garrison (McGraw-Hill/Irwin, 2008). Case 4-33 Cost Structure; Target profit and Break-Even Analysis

Contribution Income Statement for all three scenarios:

15% commission20% commissionOwn sales force

Sales$16,000,000$16,000,000$16,000,000
Variable manuf. cost$7,200,000$7,200,000$7,200,000
Commissions $2,400,000$3,200,000$1,200,000
-Tot. variable cost ($9,600,000)($10,400,000) ($8,400,000) Contribution margin $6,400,000 $5,600,000 $7,600,000 Fixed overhead$2,340,000$2,340,000$2,340,000
Fixed marketing$120,000$120,000$2,520,000
Fixed administrating $1,800,000$1,800,000$1,725,000
Fixed interest$540,000$540,000$540,000
-Tot. fixed cost($4,800,000)($4,800,000)($7,125,000) Income before tax $1,600,000 $800,000 $475,000 Tax 30% ($480,000) ($240,000) ($142,500)
Net Income $1,120,000 $560,000 $332,500

In the third scenario of Pittman’s own sales force, I included the salaries of sales manager, salespeople, travel, entertainment, and advertising expenses under fixed marketing expense and I reduced fixed administrating expenses by $75,000:

Fixed marketing = $120,000+$2,400,000=$2,520,000
Administrating expense: $1,800,000-$75,000=$1,725,000

Contribution margin for all three scenarios:

15% commission20% commissionOwn sales force
Tot. Contribution margin$6,400,000$5,600,000$7,600,000
Sales$16,000,000$16,000,000$16,000,000
CM Ratio (TCM/Sales)40%35%47.5%

1. Compute Pittman’s break-even point in sales dollars for next year for all three scenarios

a) The agents’ commission remains unchanged at 15%

BE point = Fixed costs/CM ratio = $4,800,000/0.4 = $12,000,000

b) The agents’ commission is increased to 20%

BE point = $6,400,000/0.35 = $13,714,286

c) The company employs its own sales force

BE point = $7,125,000/0.475 = $15,000,000

2. Assume that Pittman decides to continue selling through the agents and pays the 20% commission rate. Determine the volume of sales that would be required to generate the same net income as contained in the budgeted income statement for next year.

Target income before taxes = $1,600,000
Target sales volume = (Target income + Fixed expenses) / (CM ratio) = $18,285,714

3. Determine the volume of sales at which net income would be equal regardless of whether Pittman sells through agents (at a 20% commission rate) or employs its own sales force.

NOI = (CM ratio x Sales) – Fixed expenses
Under 20% commission NOI = (0.35 x sales) - ($4,800,000)
Under own sales NOI = (0.475 x sales) – ($7,125,000)

In order to obtain the same NOI sales volume needs to be $18,600,000

4. Compute the degree of operating leverage that the company would have to have on December 31 at the end of next year assuming:

a) The agents’ commission remains unchanged at 15%:

Operating leverage = Contribution margin/Income

Operating leverage = $6,400,000/$1,600,000 = 4

b) The agents’ commission is increased to 20%

Operating leverage = $5,600,000/$800,000 = 7

c) The company employs its own sales force

Operating leverage = $7,600,000/$475,000 = 15

5. Recommendation.

In this case Pittman Company, a growing manufacturer of telecommunication equipment is faced with the decision of hiring its own sales force for the sale and promotion of its products or maintaining its current outsourced sales agents that have increasing commission demands. The current sales commission paid to the outsourced sales agents is 15%, but Pittman just learned that the rate will become 20% in the following year. This will generate an increase in Pittman’s variable costs and therefore diminish its future contribution margin. If the company hires its own sales force (including a sales manager), it could pay...
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