Question

HOT AIR Company of Atlanta sells fans and heaters to retail outlets throughout the Southeast. Joe Smith, the president of the company, is thinking about changing the firm's credit policy to attract customers away from competitors. The present policy calls for a 1/10, net 30 cash discount. The new policy would call for a 3/10, net 50 cash discount. Currently, 30 percent of Hot Air customers are taking the discount, and it is anticipated that this number would go up to 50 percent with the new discount policy. It is further anticipated that annual sales would increase from a level of $400,000 to $600,000 as a result of the change in the cash discount policy. The increased sales would also affect the inventory level. The average inventory carried by Hot Air is based on a determination of an EOQ. Assume sales of fans and heaters increase from 15,000 to 22,500 units. The ordering cost for each order is $200 and the carrying cost per unit is $1.50 (these values will not change with the discount). The average inventory is based on EOQ/2. Each unit in inventory has an average cost of $12. Cost of goods sold is equal to 65 percent of net sales, general and administrative expenses are 15 percent of net sales, and interest payments of 14 percent will only be necessary for the increase in the accounts receivable and inventory balances. Taxes will be 40 percent of before-tax income. Compute the accounts receivable balance before and after the change in the cash discount policy. Use the net sales (total sales minus cash discounts) to determine the average daily sales. Determine EOQ before and after the change in the cash discount policy. Translate this into average inventory (in units and dollars) before and after the change in the cash discount policy. Complete the following income statement. a. b. Before Policy Change After Policy Change Net sales (Sales - Cash discounts). Cost of goods sold... Gross profit...... General and administrative expense............. Operating profit.. Interest on increase in accounts receivable and inventory (14%). Income before taxes.. Taxes... Income after taxes. d. Should the new cash discount policy be utilized? Briefly comment.

Answer 1

Solution:

a) Calculation of the Accounts Receivable Balance before and After the Change in the Cash Discount Policy:

$\emph{Accounts receivable = Average Collection * Average daily period sales}$

Before Change in the Cash Discount:

Average collection period
0.30 * 10 days	3
0.30 * 10 days	21
Average Accounts Receivables	24 Days

$\emph{Average Daily sales} = \frac{\emph{Credit sales Discount}}{360 days}$

$\emph{Average Daily sales} = \frac{\$400,000 - (0.01 * 0.30 * \$400,000)}{360 Days}$

$\emph{Average Daily sales} = \frac{\$400,000 - \$1,200}{360 Days}$

$\emph{Average Daily sales} = \frac{\$398,800}{360 Days}$

$\emph{Average Daily sales} = \$1,107.78$

$\emph{Accounts receivable before policy change} = 24 days * \$1,107.78$

$\emph{Accounts receivable before policy change} = \$26,586.72$

Therefore, the Accounts Receivable Before the Policy Change is $26,586.72.

After Change in the Cash Discount:

Average collection period
0.50 * 10 days	5
0.50 * 10 days	25
Average Accounts Receivables	30 Days

$\emph{Average Daily sales} = \frac{\emph{Credit sales Discount}}{360 days}$

$\emph{Average Daily sales} = \frac{\$600,000 - (0.03 * 0.50 * \$600,000)}{360 Days}$

$\emph{Average Daily sales} = \frac{\$600,000 - \$9,000}{360 Days}$

$\emph{Average Daily sales} = \frac{\$591,000}{360 Days}$

$\emph{Average Daily sales} = \$1,641.67$

$\emph{Accounts receivable After policy change} = 30 days * \$1,641.67$

$\emph{Accounts receivable After policy change} = \$49,250.10$

Therefore, the Accounts Receivable After the Policy Change is $49,250.10.

b) Calculation of the EOQ Before and After the Cash Discount Policy:

Before Change in the Cash Discount:

$EOQ =\sqrt{ \frac{2SO}{C}}$

$EOQ =\sqrt{ \frac{2*15,000*\$200}{\$1.50}}$

$EOQ =\sqrt{ \frac{\$6,000,000}{\$1.50}}$

$EOQ =\sqrt{\$4,000,000}$

$EOQ = 2,000 Units$

After Change in the Cash Discount:

$EOQ =\sqrt{ \frac{2SO}{C}}$

$EOQ =\sqrt{ \frac{2*22,000*\$200}{\$1.50}}$

$EOQ =\sqrt{ \frac{\$9,000,000}{\$1.50}}$

$EOQ =\sqrt{\$6,000,000}$

$EOQ = 2,449.49 Units$

Calculation of the Average Inventory Before and After the Cash Discount Policy:

Before Change in the Cash Discount:

$\emph{Average Inventory = } \frac{2,000}{2} \Rightarrow 1,000 Units$

$\Rightarrow 1,000 Units * \$12 = \$12,000$

After Change in the Cash Discount:

$\emph{Average Inventory = } \frac{2,449.49}{2} \Rightarrow 1,225 Units (Rounded)$

$\Rightarrow 1,225 Units * \$12 = \$14,700$

c) Completing the Following Income Statement Before Policy and After Policy Change:

	Before Policy Change	After Policy Change
Net sales (sales - cash discount)	$398,800	$591,000
Cost of goods sold (65%)	$259,220	$384,150
Gross Profit	$139,580	$206,850
General and admin. expense (15%)	$59,820	$88,650
Operating profit	$79,760	$118,200
Interest on increase in accounts receivable and inventory (14%)		$3,550.45
Income before taxes	$79,760	$114,649.55
Taxes (40%)	$31,904	$45,859.82
Income after taxes	$47,856	$68,789.73

d) Yes, the Cash Discount Policy Should be Utilized. When Compared to the Interest Cost on the Increased Accounts Receivable and Inventory it is Small in Comparision to the Increased Operating Profit from the Policy Change.