Question

# A company currently has annual sales of Rs. 500,000 and an average collection period of 30...

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.

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

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