Question

Sea Water Ltd is wholesale supplier of seafoods based in Swakopmund. Recently the company has experienced a continuous decline in profitability. A new management team has been employed in an attempt to reverse the situation. One of the issues to be addressed is whether or not the company’s credit policy should be changed. At present the company’s credit terms 1/15, net 45. All sales at present and in future will be on credit and at present 20% of the customers take advantages of the discounts. A major factor affecting profitability appears to be the fact that the company’s bad debt losses amounts to 10% of sales for which discounts are not taken. In order to rectify this situation, management is considering the more effective use of discounts to encourage early payment. The new credit term will be 2/10, net 30. It is expected that this policy will result bad debts amounting to 2% of credit sales. Furthermore, only 35% of the customers are not likely to use the new discount facilities.

Management expects that the new credit policy is likely to increase annual sales slightly from N$17 million to N$19 million. It is estimated that the gross profit margin will remain unchanged at 20% and that opportunity cost is 10%.

The increase in sales is also expected to impact on the level of inventory carried by Sea Water Ltd. The company uses EOQ model to determine its average inventory level. Unit sales of seafoods is expected to increase from 16 000 to 18 000. The carrying cost per unit is N$5 and the ordering cost is N$200 for each order. Sea Water Ltd does not carry safety inventory.

Required:

Calculate whether the new credit policy should be implemented or not, using 360 days as the number of days in the year. Sow all your workings

Answer 1

Therefore as per New policy profit is 33.18 lakhs vs 20.06 Lakhs as per Old Policy

Note: Calculation was made in Lakh for your convenience