Question

A company currently has annual sales of Rs. 500,000 and an average collection period of 30 days. It is considering a more liberal credit policy. If the credit period is extended, the company expects sales and bad-debt losses to increase in following manner:
Credit policy Increase in credit period Increase in sale (Rs) Bad debts % of total sales
A 10 days 25,000 1.2
B 15 35,000 1.5
C 30 40,000 1.8
D 42 50,000 2.2
The selling price per unit is Rs 2. Average cost per unit at the current level of operations is Rs. 1.50 and variable cost per unit is Rs. 1.20. if current bad debt loss is 1% and required rate of return on investment is 20%, which credit policy should be undertaken? Ignore taxes and assume 360 days in a year.

Answer 1

Current Quantity = Sales/Selling Price per unit = 500000/2 = 250000

Current Total Cost = Qty*Average Total Cost = 250000*1.5 = 375000

Current Variable Cost = Qty*Variable Cost per unit = 250000*1.2 = 300000

Therefore, Fixed Cost = Total Cost - Variable Cost = 375000 - 300000 = $75000

Contribution per unit = Selling Price per unit - Variable Cost per unit = 2-1.2 = $0.8

	Current	A	B	C	D
Sales	500000	525000	535000	540000	550000
Quantity [Sales/2]	250000	262500	267500	270000	275000
Contibution [Quantity*Contribution per unit i.e. 0.8]	200000	210000	214000	216000	220000
Less: Fixed Cost	75000	75000	75000	75000	75000
Bad Debts as % of Sales	1%	1.20%	1.50%	1.80%	2.20%
Less: Bad Debts [Sales*Bad Debts %]	5000	6300	8025	9720	12100
Profit [Contribution-Fixed Cost-Bad Debts]	120000	128700	130975	131280	132900
Credit Period	30	10	15	30	42
Less: NOTIONAL Interest Cost [(Sales-Bad Debt)*0.2*(Credit Period/360)]	8250	2881.67	4391.458	8838	12551
Net Gain [Profit-Notional Interest Cost]	111750	125818	126583.5	122442	120349

Option B should be undertaken