Choosing between compensation plans, operating leverage

(CMA, adapted) BioPharm Corporation manufactures pharmaceutical products that are sold through a network of external sales agents. The agents are paid a commission of 20% of revenues. BioPharm is considering replacing the sales agents with its own salespeople, who would be paid a commission of 13% of revenues and total salaries of $2,240,000. The income statement for the year ending December 31, 2013, under the two scenarios is shown here.

Required:
1. Calculate BioPharm's 2013 contribution margin percentage, breakeven revenues, and degree of operating leverage under the two scenarios.
2. Describe the advantages and disadvantages of each type of sales alternative.
3. In 2014, BioPharm uses its own salespeople, who demand a 16% commission. If all other cost-behavior patterns are unchanged, how much revenue must the salespeople generate in order to earn the same operating income as in 2013?

1. We can recast BioPharm's income statement to emphasize contribution margin, and then use it to compute the required CVP parameters.

BioPharm Corporation

Income Statement for the Year Ended December 31, 2014

Using Sales Agents Using Own Sales Force
Revenues $32,000,000 $32,000,000
Variable Costs
Cost of goods sold—variable $12,160,000 $12,160,000
Marketing commissions 6,400,000 18,560,000 4,160,000 16,320,000
Contribution margin 13,440,000 15,680,000
Fixed Costs
Cost of goods sold—fixed 3,750,000 3,750,000
Marketing—fixed 3,660,000 7,410,000 5,900,000 9,650,000
Operating income $ 6,030,000 $ 6,030,000

Contribution margin percentage ($13,440,000 $32,000,000; $15,680,000 $32,000,000)
42% 49%
Breakeven revenues
($7,410,000 0.42; $9,650,000 0.49)
$17,642,857
$19,693,878

Degree of operating leverage
($13,440,000 $6,030,000; $15,680.000 $6,030,000)
2.23 2.60

2. The calculations indicate that at sales of $32,000,000, a percentage change in sales and contribution margin will result in 2.23 times that percentage change in operating income if BioPharm continues to use sales agents and 2.60 times that percentage change in operating income if BioPharm employs its own sales staff. The higher contribution margin per dollar of sales and higher fixed costs gives BioPharm more operating leverage, that is, greater benefits (increases in operating income) if revenues increase but greater risks (decreases in operating income) if revenues decrease. BioPharm also needs to consider the skill levels and incentives under the two alternatives. Sales agents have more incentive compensation and, hence, may be more motivated to increase sales. On the other hand, BioPharm's own sales force may be more knowledgeable and skilled in selling the company's products. That is, the sales volume itself will be affected by who sells and by the nature of the compensation plan.

3. Variable costs of marketing = 16% of Revenues
Fixed marketing costs = $5,900,000
Operating income = Revenues ? ? ? ?
Denote the revenues required to earn $6,030,000 of operating income by R, then

R ? 0.38R ? $3,750,000 ? 0.16R ? $5,900,000 = $6,030,000
R ? 0.38R ? 0.16R = $6,030,000 + $3,750,000 + $5,900,000
0.46R = $15,680,000
R = $15,680,000? 0.46 = $34,086,957