1. Assuming sales of $15,000,000, construct a budgeted contribution format income statement for the upcoming year for each of the following alternatives
PhysicsGeneralWorked Solution
Crescent Corporation manufactures multi-function photocopiers that are sold to businesses through a network of independent sales agents located in the United States and Canada. These sales agents sell a variety of products to businesses in addition to Crescent’s multi-function photocopiers. The sales agents are currently paid a 19% commission on sales, and this com- mission rate was used when Crescent’s management prepared the following budgeted income statement for the upcoming year:
Since the completion of the above statement, Crescent’s management has learned that the independent sales agents are demanding an increase in the commission rate to 22% of sales for the upcoming year. This would be the third increase in commissions demanded by the independent sales agents in five years. As a result, Crescent’s management has decided to investigate the possibility of hiring its own sales staff to replace the independent sales agents.
Crescent’s controller estimates that the company would have to hire six salespeople to cover the current market area, and the total annual payroll cost of these employees would be about $350,000, including benefits. The salespeople would also be paid commissions of 12% of sales. Travel and entertainment expenses are expected to total about $200,000 for the year. The company would also have to hire a sales manager and support staff, whose salaries and benefits would total $100,000 per year. To make up for the promotions that the independent sales agents had been running on behalf of Crescent, management believes that the company’s bud- get for fixed advertising expenses should be increased by $250,000.
Required:
1. Assuming sales of $15,000,000, construct a budgeted contribution format income statement for the upcoming year for each of the following alternatives:
a. The independent sales agents’ commission rate remains unchanged at 19%.
b. The independent sales agents’ commission rate increases to 22%.
c. The company employs its own sales force.
2. Calculate Crescent Corporation’s break-even point in sales dollars for the upcoming year assuming the following:
a. The independent sales agents’ commission rate remains unchanged at 19%.
b. The independent sales agents’ commission rate increases to 22%.
c. The company employs its own sales force.
3. Refer to your answer to 1(b) above. If the company employs its own sales force, what volume of sales would be necessary to generate the operating income the company would realize if sales are $15,000,000 and the company continues to sell through agents (at a 22% commission rate)?
4. Determine the volume of sales at which operating income would be equal regardless of whether Crescent Corporation sells through agents (at a 22% commission rate) or employs its own sales force.
5. Prepare a profit graph on which you plot the profits for both of the following alternatives:
a. The independent sales agents’ commission rate increases to 22%.
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b. The company employs its own sales force. On the graph, use total sales revenue as the measure of activity.
6. Write a memo to the president of Crescent Corporation in which you recommend whether the company should continue to use independent sales agents (at a 22% commission rate) or employ its own sales force. Fully explain the reasons for your recommendation in the memo.
SOLUTION
1. The contribution format income statements (in thousands of dollars) for the three alternatives are:
19% Commission
19% Commission
19% Commission
19% Commission
22% Commission
22% Commission
22% Commission
22% Commission
Own Sales Force
Own Sales Force
Own Sales Force
Own Sales Force
Sales
$15,000
100
%
$15,000
100
%
$15,000
100
%
Variable expenses:
Variable cost of goods sold
8,400
8,400
8,400
Commissions
2,850
3,300
1,800
Total variable expense
11,250
75
%
11,700
78
%
10,200
68
%
Contribution margin
3,750
25
%
3,300
22
%
4,800
32
%
Fixed expenses:
Fixed cost of goods sold
1,400
1,400
1,400
Fixed advertising expense
400
400
650
*
Fixed marketing staff expense
650
**
Fixed administrative expense
1,600
1,600
1,600
Total fixed expenses
3,400
3,400
4,300
Operating income
$ 350
($ 100)
$ 500
*
$400,000 + $250,000 = $650,000
**
$350,000 + $200,000 + $100,000 = $650,000
2.
Given the data above, the break-even points can be determined using total fixed expenses and the CM ratios as follows:
Fixed expenses/CM ratio =$3,400,000/0.25 =$13,600,000
Fixed expenses/CM ratio =$3,400,000/0.22 =$15,454,545
Fixed expenses/CM ratio =$4,300,000/0.32 =$13,437,500
3. Dollar sales to attain target profit
=Fixed expenses + Target profit (Loss)/CM ratio
=$4,300,000 - $100,000/0.32 =$13,125,000
4.
Operating income with company sales force = .32x - $4,300,000
Operating income with 22% sales commissions: .22x - $3,400,000
Where x = total sales revenue
The two operating incomes are equal when:
CM – fixed expenses
=
CM – fixed expenses
0.32X – $4,300,000
=
0.22X – $3,400,000
0.10X
=
$900,000
X
=
$900,000 ÷ 0.10
X
=
$9,000,000
Thus, at a sales level of $9,000,000 either plan will yield the same operating income. This is verified below (in thousands of dollars):
22% Commission
22% Commission
22% Commission
Own Sales Force
Own Sales Force
Own Sales Force
Sales
$ 9,000
100
%
$ 9,000
100
%
Total variable expense
7,020
78
%
6,120
68
%
Contribution margin
1,980
22
%
2,880
32
%
Total fixed expenses
3,400
4,300
Operating income
$ (1,420)
$ (1,420)
5.
A profit graph showing both alternatives appears below:
6.
To:
President of Crescent Corporation
Fm:
Student’s name
Assuming that a competent sales force can be quickly hired and trained and the new sales force is as effective as the sales agents, this is the better alternative. Using the data provided by the controller, operating income is higher when the company has its own sales force unless sales fall below $9,000,000. At that level of sales and below, the company would be losing money so it is unlikely that this would be the normal situation.
The major concern with this recommendation is the assumption that the new sales force will be as effective as the existing sales agents. The sales agents have been selling our product for a number of years, so they are likely to have more field experience than any sales force we hire. And, our own sales force would be selling just our product instead of a variety of products. On the one hand, that will result in a more focused selling effort. On the other hand, that may make it more difficult for a salesperson to get the attention of a business’s purchasing agent.
The purchasing agents may prefer to deal through a small number of salespersons each of whom sells many products rather than a large number of salespersons each of whom sells only a single product. Even so, we can afford some decrease in sales because of the lower cost of maintaining our own sales force. For example, assuming that the sales agents make the budgeted sales of $15,000,000, we would have a operating loss of $100,000 for the year. We would do better than this with our own sales force as long as sales are greater than $13,125,000. In other words, we could afford a decrease in sales of $1,875,000 or 12.5% and still be better off with our own sales force. If we are confident that our own sales force could do at least this well relative to the sales agents, then we should switch to using our own sales force.