Given i we may now determine the incremental profit p

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Unformatted text preview: oposed credit period change, using Equation 27-3: P (SN S0)(1 V) r( I) (BNSN B0S0) (DNSNPN ($50,000)(0.4) 0.10($10,685) [0.02($150,000) $20,000 $1,069 $3,000 $15,931. D0S0P0) 0.00($100,000)] $0 Since pre-tax profits are expected to increase by $15,931, the credit policy change appears to be desirable. Two simplifying assumptions that were made in our analysis should be noted: We assumed (1) that all customers paid on time (DSO credit period), and (2) that there were no current bad debt losses. The assumption of prompt payment can be relaxed quite easily—we can simply use the actual days sales outstanding (say, 40 days), rather than the 30-day credit period, to calculate the investment in receivables, and then use this new (and higher) value of I in Equation 27-3 to calculate P. Thus, if DSON were 40 days, then the increased investment in receivables would be I [(40 0)($100,000/365)] 0.6[40($50,000/365)] $10,959 $3,288 $14,247, and the change in pre-tax profits would be P $50,000(0.4) 0.10($14,247) 0.02($150,000) $20,000 $1,425 $3,000 $15,575. The longer collection period causes incremental profits to fall slightly, but they are still positive, so the credit policy should probably still be relaxed. Analyzing Proposed Changes in Credit Policy: Incremental Analysis 27-15 If the company had been selling on credit initially and therefore incurring some bad debt losses, then we would have had to include this information in Equation 27-3. In our example, B0S0 was equal to zero because Stylish Fashions did not previously sell on credit; therefore, the change in bad debt losses was equal to BNSN. Note that BN is defined as the average credit loss percentage on total sales, and not just on incremental sales. Bad debts might be higher for new customers attracted by the credit terms than for old customers who take advantage of them, but BN is an average of these two groups. However, if one wanted to keep the two groups separate, it would be easy enough to define BN as the bad debt percentage of the incremental sales only. Other factors could be introduced into the analysis. For example, the company could consider a further easing of credit by extending the credit period to 60 days, or it could analyze the effects of a sales expansion so great that fixed assets, and hence additional fixed costs, had to be added. Or the variable cost ratio might change as sales increased, falling if economies of scale were present or rising if diseconomies were present. Adding such factors complicates the analysis, but the basic principles are the same—just keep in mind that we are seeking to determine the incremental sales revenues, the incremental costs, and consequently the incremental before-tax profit associated with a given change in credit policy. Shortening the Credit Period Suppose that one year after Stylish Fashions began offering 30-day credit terms, management decided to consider the possibility of shortening the credit period from 30 to 20 days. It was believed that sales would decline by $20,000 per year from the current level, $150,000, so SN $130,000. It was also believed that the bad debt percentage on these lost sales would be 2 percent, the same as on other sales, and that all other values would remain as given in the last section. We first calculate the incremental investment in receivables. Because the change in credit policy is expected to decrease sales, Equation 27-2 is used: I [(DSON DSO0)(SN/365)] V[(DSO0)(SN [(20 30)($130,000/365)] 0.6[30($130,000 ( 10)($356.16) 0.6[(30)( $54.79)] $3,562 $986 $4,548. S0)/365] $150,000)/365] With a shorter credit period there is a shorter collection period, so sales are collected sooner. There is also a smaller volume of business, and hence a smaller investment in receivables. The first term captures the speedup in collections, while the second reflects the reduced sales, and hence the lower receivables investment (at variable cost). Note that V is included in the second term but not in the first one. The logic here is parallel to that with regard to Equation 27-1. V is included in the second term because, by shortening the credit period, Stylish Fashions will drive off some customers and lose sales of $20,000 per year, or $54.79 per day. The firm’s investment in those sales was only 60 percent of the average receivables outstanding, or 0.6(30)($54.79) $986. However, the situation is different for the remaining customers. They would have paid their full purchase price—variable cost plus profit— after 30 days. Now, however, they will have to pay this amount 10 days sooner, so those funds will be available to meet operating costs or for investment. Thus, the first term should not be reduced by the variable cost factor. Therefore, in total, reducing the credit period would result in a $4,548 reduction in the investment in receivables, consisting of a $3,562 decline in receivables associated with continuing customers and a further $986 decline in investment as a result of the reduced sales volume. 27-16 Chapter 27 Providing and Obtaining Credit With the change in investment calculated,...
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This document was uploaded on 01/20/2014.

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