Receivable management | WCM| Practice Queston

Altman Auto Parts is considering changing its credit terms from 2/15 net 30, to 3/10 net 30, in order to speed collections. At present, 60 percent of the firm's customers take the 2 percent discount. Under the new terms, discount customers are expected to rise to 70 percent. Regardless of the credit terms, half of the customers who do not take the discount are expected to pay on time, while the remainder will pay 10 days late. The change does not involve a relaxation of credit standards; therefore, bad debt losses are not expected to rise above their present 2 percent level. However, the more generous cash discount terms are expected to increase sales from Rs.1 million to Rs.1.2 million per year. Firm's variable cost ratio is 75 percent, the interest rate on funds invested in accounts receivable is 12 percent, and its tax rate is 40 percent.

a. What is the days sales outstanding before and after the change?
b. Calculate the discount costs before and after the change.
C. Calculate the rupee cost of carrying receivables before and after the change.
d. Calculate the bad debt losses before and after the change.
e. What is the incremental profit from the change in credit terms? Should the firm change its credit terms?

Solution 

Given: 

Particular	Before change	After change
Credit terms	2/15, net 30	3/10, net 30
Discount taker customer	60%	70%
Non-discount customer who pay on time	20%	15%
Bad debt loss ratio	2%	2%
Sales	1 million	12 million
Variable cost ratio (v)	75% or 0.75
Interest rate (k)	12%
Tax rate (T)	40%

a. DSO = ?

We have, DSO = % of customer taking discount × discount period + % of customers not taking discount × Net period + % of customer paying in late × late period

DSO₀ = 0.60 × 15 days + 0.20 × 30 days + 0.20 × 40 days = 23 days

DSOₙ = 0.70 × 10 days + 0.25 × 30 days + 0.15 × 40 days = 17.5 days b. Discounts costs =?

We have, Discount costs = sales × discount rate × % of customers taking discount D₀ = Rs.1,000,000 × (1 - 0.02) × 0.02 × 0.60 = Rs 11,760 Dₙ = Rs.1,200,000 × (1 - 0.02) × 0.03 × 0.70 = Rs 24,696 Marginal discounts costs = New discount costs - current discount costs = Rs.24,696 - Rs.11,760 = Rs 12,936 c. Cost of carrying receivables =? We have, Cost of carrying receivables = DSO × daily sales × VC ratio × cost of funds C₀ = 23 days × Rs.1,000,000 ÷ 360 days × 0.75 × 0.12 = Rs 5,750 Cₙ = 17.5 days × Rs.1,200,000 ÷ 360 days × 0.75 × 0.12 = Rs 5,250 Marginal carrying costs = New carrying costs - current carrying costs = Rs 5,250 - Rs.5,750 = (Rs. 500) d. Bad debt losses =? We have, Bad debt losses = Sales × Bad debt ratio B₀ = Rs.1,000,000 × 0.02 = Rs.20,000 Bₙ = Rs.1,200,000 × 0.02 = Rs.24,000 Marginal bad debt costs = New bad debt costs - current bad debt costs = Rs.24,000 - Rs.20,000 = Rs.4,000

e. Incremental profits(ΔP) = ? - Rs.24,000 - Rs.20,000 = Rs.4,000

	Before change	After change
Gross Sales	Rs.1,000,000	Rs.1,200,000
Less:- Discounts	11,760	24,696
Net sales	Rs.988,240	Rs.1,175,304
Less:- Production costs (75%)	750,000	900,000
Profit before credit costs and taxes	Rs.238,240	Rs.275,304
Less:- Credit related costs
- Bad debt losses	20,000	24,000
- Cost of carrying receivables	5,750	5,250
Profit before tax	Rs.212,490	Rs.246,054
Less:- Tax (40%)	Rs.84,996	Rs.98,421.6
Net income	Rs.127,494	Rs.147,634.4

Decision: Altman Auto Parts should change the credit terms to 3/10, net 30, from 2/15, net 30 because profit after change is increasing by Rs 20,140.4 (Rs.147,634.4 - Rs.127,494)