PneumoTech, Inc. is studying the addition of a new valve to its product line. The valve would be used by manufacturers of pneumatic equipment. The company anticipates starting with a relatively low sales volume and then boosting demand over the next several years. A new salesperson must be hired because PneumoTech’s current sales force is working at capacity. Two compensation plans are under consideration:
Plan A: An annual salary of $ 33,000 plus a 10% commission based on gross dollar sales.
Plan B: An annual salary of $ 99,000 and no commission.
PneumoTech, Inc. will purchase the valve for $ 75 and sell it for $ 120. Anticipated demand during the first year is 6,000 units. (In the following requirements, ignore income taxes.)
1. Compute PneumoTech’s break- even point for Plan A and Plan B.
2. What is meant by the term operating leverage?
3. Analyze the cost structures of both plans at the anticipated demand of 6,000 units. Which of the two plans is more highly leveraged? Why?
4. Assume that a general economic downturn occurred during year 2, with product demand falling from 6,000 to 5,000 units. Determine the percentage decrease in company net income if PneumoTech had adopted Plan A.
5. Repeat requirement (4) for Plan B. Compare Plan A and Plan B, and explain a major factor that underlies any resulting differences.
6. Briefly discuss the likely profitability impact of an economic recession for highly automated manufacturers. What can you say about the risk associated with these firms?