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$0.197 $197,000. v)(r) For simplicity, we have ignored this opportunity cost in our analysis. However, we consider opportunity costs in the
next section, where we discuss incremental analysis. Analyzing Proposed Changes in Credit Policy: Incremental Analysis Self-Test Questions 27-11 Describe the procedure for evaluating a change in credit policy using the
income statement approach.
Do you think that credit policy decisions are made more on the basis of numerical analyses or on judgmental factors? Analyzing Proposed Changes in Credit
Policy: Incremental Analysis
To evaluate a proposed change in credit policy, one could compare alternative projected income statements, as we did in Table 27-4. Alternatively, one could develop
the data in Column 2, which shows the incremental effect of the proposed change
without first developing the pro forma statements. This second approach is often
preferable—because firms usually change their credit policies in specific divisions or
on specific products, and not across the board, it may not be feasible to develop
complete corporate income statements. Of course, the two approaches are based on
exactly the same data, so they should produce identical results.
In an incremental analysis, we attempt to determine the increase or decrease in
both sales and costs associated with a given easing or tightening of credit policy. The
difference between incremental sales and incremental costs is defined as incremental profit. If the expected incremental profit is positive, and if it is sufficiently large
to compensate for the risks involved, then the proposed credit policy change should
be accepted. The Basic Equations
To ensure that all relevant factors are considered, it is useful to set up some equations to analyze changes in credit policy. We begin by defining the following terms
and symbols:
S0
SN
SN S0
V 1 V r
DSO0
DSON
B0
BN
P0 current gross sales.
new gross sales, after the change in credit policy. Note that SN can be
greater or less than S0.
incremental, or change in, gross sales.
variable costs as a percentage of gross sales. V includes production
costs, inventory carrying costs, the cost of administering the credit
department, and all other variable costs except bad debt losses,
financing costs associated with carrying the investment in receivables,
and costs of giving discounts.
contribution margin, or the percentage of each gross sales dollar that
goes toward covering overhead and increasing profits. The contribution margin is sometimes called the gross profit margin.
cost of financing the investment in receivables.
days sales outstanding prior to the change in credit policy.
new days sales outstanding, after the credit policy change.
average bad debt loss at the current sales level as a percentage of current gross sales.
average bad debt loss at the new sales level as a percentage of new
gross sales.
percentage of total customers (by dollar amount) who take discounts
under the current credit policy. That is, the percentage of gross sales
that are discount sales. Chapter 27 Providing and Obtaining Credit PN percentage of total customers (by dollar amount) who will take discounts under the new credit policy.
discount percentage offered at the present time.
discount percentage offered under the new credit policy. D0
DN With these definitions in mind, we can calculate values for the incremental change
in the level of the firm’s investment in receivables, I, and the incremental change in
pretax profits, P. The formula for calculating I differs depending on whether the
change in credit policy results in an increase or decrease in sales. Here we simply
present the equations; we discuss and explain them shortly, through use of examples, once all the equations have been set forth.
If the change is expected to increase sales—either additional sales to old customers or sales to newly attracted customers, or both—then we have this situation:
Formula for I if Sales Increase: Increased investment in
£ receivables associated with §
original sales I c Increased investment in
£ receivables associated §
with incremental sales Old sales
Change in days
d
dc
per day
sales outstanding [DSON DSO0) (S0 /365] V c (DSON) a Incremental
bd
sales per day V[(DSON)(SN (27-1) S0)/365]. However, if the change in credit policy is expected to decrease sales, then the change
in the level of investment in receivables is calculated as follows:
Formula for I I if Sales Decrease: Decreased investment in
£ receivables associated with §
customers who left Decreased investment in
£ receivables associated with §
remaining original customers
£ Change in days Remaining
sales
§£ sales §
outstanding
per day [DSON V £ (DSO0) ° DSO0) (S0 /365] Incremental
sales
¢§
per day V[(DSON)(SN (27-2) S0)/365]. With the change in receivables investment calculated, we can now analyze the pretax profitability of the proposed change: (SN Change in gross profit S0) (1 V) P P: Change in cost of carrying receivables r( I) Formula for Change in bad debt losses (BNSN B0S0) 27-12 Change in cost of discounts (DNSNPN D0S0P0). (27-3) Analyzing Proposed Changes in Credit Poli...

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