Question
Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own; rather, it relies 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, just prepared the company’s budgeted income statement for next year as follows:
Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales $ 16,000,000
Manufacturing expenses:
Variable $ 7,200,000
Fixed overhead 2,340,000 9,540,000
Gross margin 6,460,000
Selling and administrative expenses:
Commissions to agents 2,400,000
Fixed marketing expenses 120,000*
Fixed administrative expenses 1,800,000 4,320,000
Net operating income 2,140,000
Fixed interest expenses 540,000
Income before income taxes 1,600,000
Income taxes (30%) 480,000
Net income $ 1,120,000
*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 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 after paying for advertising, travel, and the other costs of promotion, there’s nothing left over for profit,” replied Barbara.
“That’s ridiculous,” 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 of 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 $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% × $16,000,000) we would avoid on agents’ commissions.”
The breakdown of the $2,400,000 cost follows:
Salaries:
Sales manager $ 100,000
Salespersons 600,000
Travel and entertainment 400,000
Advertising 1,300,000
Total $ 2,400,000
“Super,” replied Karl. “And I noticed the $2,400,000 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 $75,000 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.”
Compute the degree of operating leverage the company would expect to have at the end of next year assuming:
The agents’ commission rate remains unchanged at 15%.
Barbara Cheney, Pittman’s controller, just prepared the company’s budgeted income statement for next year as follows:
Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales $ 16,000,000
Manufacturing expenses:
Variable $ 7,200,000
Fixed overhead 2,340,000 9,540,000
Gross margin 6,460,000
Selling and administrative expenses:
Commissions to agents 2,400,000
Fixed marketing expenses 120,000*
Fixed administrative expenses 1,800,000 4,320,000
Net operating income 2,140,000
Fixed interest expenses 540,000
Income before income taxes 1,600,000
Income taxes (30%) 480,000
Net income $ 1,120,000
*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 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 after paying for advertising, travel, and the other costs of promotion, there’s nothing left over for profit,” replied Barbara.
“That’s ridiculous,” 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 of 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 $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% × $16,000,000) we would avoid on agents’ commissions.”
The breakdown of the $2,400,000 cost follows:
Salaries:
Sales manager $ 100,000
Salespersons 600,000
Travel and entertainment 400,000
Advertising 1,300,000
Total $ 2,400,000
“Super,” replied Karl. “And I noticed the $2,400,000 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 $75,000 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.”
Compute the degree of operating leverage the company would expect to have at the end of next year assuming:
The agents’ commission rate remains unchanged at 15%.
Answers
GPT-4o mini
To calculate the degree of operating leverage (DOL) at Pittman Company under the scenario where the agents' commission rate remains at 15%, we will use the following formula:
\[
\text{DOL} = \frac{\text{Contribution Margin}}{\text{Net Operating Income}}
\]
**Step 1: Calculate the Contribution Margin**
The contribution margin is calculated as:
\[
\text{Contribution Margin} = \text{Sales} - \text{Variable Costs}
\]
In Pittman Company's case, the variable costs include manufacturing variable expenses and the commissions to agents.
1. **Sales:** $16,000,000
2. **Manufacturing Variable expenses:** $7,200,000
3. **Commissions to agents:** 15% of Sales = \( 0.15 \times 16,000,000 = 2,400,000 \)
Now we can calculate the total variable costs:
\[
\text{Total Variable Costs} = \text{Manufacturing Variable Expenses} + \text{Commissions}
\]
\[
\text{Total Variable Costs} = 7,200,000 + 2,400,000 = 9,600,000
\]
Now we calculate the contribution margin:
\[
\text{Contribution Margin} = \text{Sales} - \text{Total Variable Costs}
\]
\[
\text{Contribution Margin} = 16,000,000 - 9,600,000 = 6,400,000
\]
**Step 2: Identify the Net Operating Income (NOI)**
From the income statement provided:
\[
\text{Net Operating Income} = 2,140,000
\]
**Step 3: Calculate the Degree of Operating Leverage**
Now we can substitute the values into the DOL formula:
\[
\text{DOL} = \frac{\text{Contribution Margin}}{\text{Net Operating Income}} = \frac{6,400,000}{2,140,000}
\]
\[
\text{DOL} \approx 2.99
\]
Thus, the degree of operating leverage (DOL) that the company would expect to have at the end of next year, assuming the agents' commission rate remains unchanged at 15%, is approximately **2.99**.
\[
\text{DOL} = \frac{\text{Contribution Margin}}{\text{Net Operating Income}}
\]
**Step 1: Calculate the Contribution Margin**
The contribution margin is calculated as:
\[
\text{Contribution Margin} = \text{Sales} - \text{Variable Costs}
\]
In Pittman Company's case, the variable costs include manufacturing variable expenses and the commissions to agents.
1. **Sales:** $16,000,000
2. **Manufacturing Variable expenses:** $7,200,000
3. **Commissions to agents:** 15% of Sales = \( 0.15 \times 16,000,000 = 2,400,000 \)
Now we can calculate the total variable costs:
\[
\text{Total Variable Costs} = \text{Manufacturing Variable Expenses} + \text{Commissions}
\]
\[
\text{Total Variable Costs} = 7,200,000 + 2,400,000 = 9,600,000
\]
Now we calculate the contribution margin:
\[
\text{Contribution Margin} = \text{Sales} - \text{Total Variable Costs}
\]
\[
\text{Contribution Margin} = 16,000,000 - 9,600,000 = 6,400,000
\]
**Step 2: Identify the Net Operating Income (NOI)**
From the income statement provided:
\[
\text{Net Operating Income} = 2,140,000
\]
**Step 3: Calculate the Degree of Operating Leverage**
Now we can substitute the values into the DOL formula:
\[
\text{DOL} = \frac{\text{Contribution Margin}}{\text{Net Operating Income}} = \frac{6,400,000}{2,140,000}
\]
\[
\text{DOL} \approx 2.99
\]
Thus, the degree of operating leverage (DOL) that the company would expect to have at the end of next year, assuming the agents' commission rate remains unchanged at 15%, is approximately **2.99**.