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Example 1 A firm is currently selling a product @ Rs 10 per unit. The most recent annual sales (all credit) were 30,000 units. The variable cost per unit is Rs .6 and the average cost per unit, given a sales volume of 30,000 units, is Rs 8. The total fixed cost is Rs 60,000. The average collection period may be assumed to be 30 days. The firm is contemplating a relaxation of credit standards that is expected to result in a 15 per cent increase in units sales; the average collection period would increase to 45 days with no change in bad debt expenses. It is also expected that increased sales will result in additional net working capital to the extent of Rs 10,000. The increase in collection expenses may be assumed to be negligible. The required return on investment is 15 per cent. Should the firm relax the credit standard? Example 2 Assume that the firm in our Example 1 is contemplating to allow 2 per cent discount for payment within 10 days after a credit purchase. It is expected that if discounts are offered, sales will increase by 15 per cent and the average collection period will drop to 15 days. Assume bad debt expenses will not be affected; return on investment expected by the firm is 15 per cent; 60 per cent of the total sales will be on discount. Should the firm implement the proposal? Example 3 Suppose, a firm is contemplating an increase in the credit period from 30 to 60 days. The average collection period which is at present 45 days is expected to increase to 75 days. It is also likely that the bad debt expenses will increase from the current level of 1 per cent to 3 per cent of sales. Total credit sales are expected to increase from the level of 30,000 units to 34,500 units. The present average cost per unit is Rs 8, the variable cost and sales per unit is Rs 6 and Rs 10 per unit respectively. Assume the firm expects a rate of return of 15 per cent. Should the firm extend the credit period? Example 4 A firm is contemplating stricter collection policies. The following details are available: 1.
At present, the firm is selling 36,000 units on credit at a price of Rs 32 each; the variable cost per unit is Rs 25 while the Rs 29; average collection period is 58 days; and collection expenses amount to Rs 10,000; bad debts are 3 per cent.
If the collection procedures are tightened, additional collection charges amounting to Rs 20,000 would be required, bad cent; the collection period will be 40 days; sales volume is likely to decline by 500 units.
Assuming a 20 per cent rate of return on investments, what would be your recommendation? Should the firm implement the Example 5
Super Sports, dealing in sports goods, has an annual sale of Rs 50 lakh and currently extending 30 days’ credit to the dealers pick up considerably if the dealers are willing to carry increased stocks, but the dealers have difficulty in financing their therefore, considering shifts in credit policy. The following information is available: The average collection period now is 30 days. Variable costs, 80 per cent of sales. Fixed costs, Rs 6 lakh per annum Required (pre-tax) return on investment: 20 per cent Credit policy
Average collection period (days)
Annual sales (Rs lakh)
D 90 Determine which policy the company should adopt.
Example 6 XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two alternative policies. Currently, the firm has annual credit sales of Rs 50 lakh and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs 1,50,000. The firm is required to give a return of 25 per cent on the investment in new accounts receivable. The company’s variable costs are 70 per cent of the selling price. Given the following information, which is a better option? Particulars Annual credit sales Accounts
Policy option I
Policy option II
turnover ratio Bad debt losses