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:
Budgeted Income Statement
For the Year Ended December 31 Sales $17,000,000 Manufacturing expenses: Variable$7,650,000 Fixed overhead 2,380,000 10,030,000 Gross margin 6,970,000 Selling and administrative expenses: Commissions to agents 2,550,000 Fixed marketing expenses 119,000* Fixed administrative expenses 1,840,000 4,509,000 Net operating income 2,461,000 Fixed interest expenses 595,000 Income before income taxes 1,866,000 Income taxes (30%) 559,800 Net income $1,306,200
*Primarily 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 $2,550,000 per year, but that would be more than offset by the $3,400,000 (20% × $17,000,000) that we would avoid on agents' commissions."
The breakdown of the $2,550,000 cost follows:
Salaries: Sales manager$106,250 Salespersons 637,500 Travel and entertainment 425,000 Advertising 1,381,250 Total$2,550,000
"Super," replied Karl. "And I noticed that the $2,550,000 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 $78,200 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."
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.