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.”
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.”
Answers
GPT-4o mini
To analyze the situation and present a case for the change in sales strategy from using independent sales agents to hiring a dedicated sales force, we can summarize and compare the financial implications of both options.
### Current Situation with Agents:
**Commissions to Agents (at 15%)**:
- Sales: $16,000,000
- Commissions: 15% of Sales = 0.15 × $16,000,000 = $2,400,000
- Fixed Marketing Expenses: $120,000
- Total Selling and Administrative Expenses:
- Commissions to agents: $2,400,000
- Fixed marketing expenses: $120,000
- Fixed administrative expenses: $1,800,000
- Total: $2,400,000 + $120,000 + $1,800,000 = $4,320,000
### Proposed Situation with In-House Sales Force:
**Necessary Changes**:
- New Commission Rate: 20%
- New Fixed Sales Cost: $2,400,000 (includes salary, travel, advertising, etc.)
- Savings from Auditing Agent Reports: $75,000
### New Calculation:
1. **Commissions to Agents (at Proposed 20%)**:
- 20% of Sales = 0.20 × $16,000,000 = $3,200,000
2. **Total Fixed Costs with New Sales Force**:
- Fixed expenses: $2,400,000 (new sales force) - $75,000 (audit savings) = $2,325,000
3. **Total Selling & Administrative Expenses with New Sales Force**:
- New Fixed Sales Expenses: $2,325,000
- Plus Manufacturing Expenses (unchanged): $9,540,000
### New Budgeted Income Statement Summary:
Using the proposed in-house sales force:
- **Sales**: $16,000,000
- **Manufacturing Expenses**: $9,540,000
- **Selling and Administrative Expenses (New)**:
- New Fixed Sales Expenses + New Commissions = $2,325,000 (fixed) + $3,200,000 (commission) = $5,525,000
- **Total Expenses**: $9,540,000 + $5,525,000 = $15,065,000
- **Net Operating Income**:
- Sales - Total Expenses = $16,000,000 - $15,065,000 = $935,000
- **Fixed Interest Expenses**: $540,000
- **Income Before Taxes**: $935,000 - $540,000 = $395,000
- **Income Taxes (30%)**: $118,500
- **Net Income**: $395,000 - $118,500 = $276,500
### Conclusion:
By transitioning to an in-house sales force, although Pittman Company would incur higher commission expenses (at 20%), the overall selling and administrative expenses could produce a lower net income than the current model since the new in-house selling structure creates a more stable cost arrangement without relying on sales agents.
### Overall Implications:
- **Current System's ROI** (with 15% commission): Net Income = $1,120,000
- **Proposed System's ROI** (with in-house sales force): Net Income = $276,500
- The financial analysis indicates that the current arrangement with sales agents, despite their demands, would be more profitable under current conditions. The proposal should be further investigated considering operational implications, potential sales effectiveness, and strategic alignment with the company’s goals.”
### Recommendation:
The management team should weigh these financial implications against non-financial considerations, such as commission reliability, control over sales strategy, and the potential impact of a dedicated sales force on company growth and customer relationships. A detailed analysis should further explore these possibilities before making a final decision.
### Current Situation with Agents:
**Commissions to Agents (at 15%)**:
- Sales: $16,000,000
- Commissions: 15% of Sales = 0.15 × $16,000,000 = $2,400,000
- Fixed Marketing Expenses: $120,000
- Total Selling and Administrative Expenses:
- Commissions to agents: $2,400,000
- Fixed marketing expenses: $120,000
- Fixed administrative expenses: $1,800,000
- Total: $2,400,000 + $120,000 + $1,800,000 = $4,320,000
### Proposed Situation with In-House Sales Force:
**Necessary Changes**:
- New Commission Rate: 20%
- New Fixed Sales Cost: $2,400,000 (includes salary, travel, advertising, etc.)
- Savings from Auditing Agent Reports: $75,000
### New Calculation:
1. **Commissions to Agents (at Proposed 20%)**:
- 20% of Sales = 0.20 × $16,000,000 = $3,200,000
2. **Total Fixed Costs with New Sales Force**:
- Fixed expenses: $2,400,000 (new sales force) - $75,000 (audit savings) = $2,325,000
3. **Total Selling & Administrative Expenses with New Sales Force**:
- New Fixed Sales Expenses: $2,325,000
- Plus Manufacturing Expenses (unchanged): $9,540,000
### New Budgeted Income Statement Summary:
Using the proposed in-house sales force:
- **Sales**: $16,000,000
- **Manufacturing Expenses**: $9,540,000
- **Selling and Administrative Expenses (New)**:
- New Fixed Sales Expenses + New Commissions = $2,325,000 (fixed) + $3,200,000 (commission) = $5,525,000
- **Total Expenses**: $9,540,000 + $5,525,000 = $15,065,000
- **Net Operating Income**:
- Sales - Total Expenses = $16,000,000 - $15,065,000 = $935,000
- **Fixed Interest Expenses**: $540,000
- **Income Before Taxes**: $935,000 - $540,000 = $395,000
- **Income Taxes (30%)**: $118,500
- **Net Income**: $395,000 - $118,500 = $276,500
### Conclusion:
By transitioning to an in-house sales force, although Pittman Company would incur higher commission expenses (at 20%), the overall selling and administrative expenses could produce a lower net income than the current model since the new in-house selling structure creates a more stable cost arrangement without relying on sales agents.
### Overall Implications:
- **Current System's ROI** (with 15% commission): Net Income = $1,120,000
- **Proposed System's ROI** (with in-house sales force): Net Income = $276,500
- The financial analysis indicates that the current arrangement with sales agents, despite their demands, would be more profitable under current conditions. The proposal should be further investigated considering operational implications, potential sales effectiveness, and strategic alignment with the company’s goals.”
### Recommendation:
The management team should weigh these financial implications against non-financial considerations, such as commission reliability, control over sales strategy, and the potential impact of a dedicated sales force on company growth and customer relationships. A detailed analysis should further explore these possibilities before making a final decision.