15-7 The president of a plastics company was quoted in a business journal as stating, "We haven't had a dollar of interest-paying debt in over 10 years. Not many companies can say that." As a stockholder in this company, how would you feel about its policy of not taking on debt?
Related questions
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, Pittmanâs controller, has just prepared the companyâs budgeted income statement for next year as follows:
| Pittman Company Budgeted Income Statement For the Year Ended December 31 | ||||||
| Sales | $ | 18,500,000 | ||||
| Manufacturing expenses: | ||||||
| Variable | $ | 8,325,000 | ||||
| Fixed overhead | 2,590,000 | 10,915,000 | ||||
| Gross margin | 7,585,000 | |||||
| Selling and administrative expenses: | ||||||
| Commissions to agents | 2,775,000 | |||||
| Fixed marketing expenses | 129,500 | * | ||||
| Fixed administrative expenses | 1,900,000 | 4,804,500 | ||||
| Net operating income | 2,780,500 | |||||
| Fixed interest expenses | 647,500 | |||||
| Income before income taxes | 2,133,000 | |||||
| Income taxes (30%) | 639,900 | |||||
| Net income | $ | 1,493,100 | ||||
*Primarily depreciation on storage facilities.
As Barbara handed the statement to Karl Vecci, Pittmanâs president, she commented, âI went ahead and used the agentsâ 15% commission rate in completing these statements, but weâve just learned that they refuse to handle our products next year unless we increase the commission rate to 20%.â
âThatâs the last straw,â Karl replied angrily. âThose agents have been demanding more and more, and this time theyâve gone too far. How can they possibly defend a 20% commission rate?â
âThey claim that after paying for advertising, travel, and the other costs of promotion, thereâs nothing left over for profit,â replied Barbara.
âI say itâs just plain robbery,â retorted Karl. âAnd I also say itâs 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?â
âWeâve already worked them up,â said Barbara. âSeveral 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 $2,775,000 per year, but that would be more than offset by the $3,700,000 (20% Ã $18,500,000) that we would avoid on agentsâ commissions.â
The breakdown of the $2,775,000 cost follows:
| Salaries: | |||
| Sales manager | $ | 115,625 | |
| Salespersons | 693,750 | ||
| Travel and entertainment | 462,500 | ||
| Advertising | 1,503,125 | ||
| Total | $ | 2,775,000 | |
âSuper,â replied Karl. âAnd I noticed that the $2,775,000 equals what weâre paying the agents under the old 15% commission rate.â
âItâs even better than that,â explained Barbara. âWe can actually save $85,100 a year because thatâs what weâre paying our auditors to check out the agentsâ reports. So our overall administrative expenses would be less.â
âPull all of these numbers together and weâll show them to the executive committee tomorrow,â said Karl. âWith the approval of the committee, we can move on the matter immediately.â
Required:
1. Compute Pittman Companyâs break-even point in dollar sales for next year assuming:
a. The agentsâ commission rate remains unchanged at 15%.
b. The agentsâ commission rate is increased to 20%.
c. 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:
a. The agentsâ commission rate remains unchanged at 15%.
b. The agentsâ commission rate is increased to 20%.
c. The company employs its own sales force.
Use income before income taxes in your operating leverage computation.
