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

Accounts Recivables
	Before Policy Change	After Police Change
Sales	$                            4,00,000	$                          6,00,000
% of customers not taking Discount	70%	50%
Customers not taking discount=Sales*% of non Discount customers	$400000*70%=$280000	$600000*50%=$300000
Customers taking discount=Sales*% of Discount customers	$400000*30%=$120000	$600000*50%=$300000	W.NO-1
Less Discount	$120000*1%=$1200	$300000*3%=$9000	W.NO-1
Accounts Recivables	$                            3,98,800	$                          5,91,000
Increase in Accounts Recivable=	$                            1,92,200

Caluculate Average Inventory Cost
1)	EOQ =	√2SD/H
	D(Annual Demand)=	15000 units
	S(Ordering cost per order)=	$200
	H(Holding Cost per Unit or Carrying cost per unit)=	$1.5
	EOQ=	√2*15000*200/1.5
	=	√6000000/1.5
	=	√4000000
	EOQ=	2000 units
	Average Inventory =	EOQ/2
	=	2000 units/2
	=	1000 units
	Average Inventory per unit =	$12
	Average Inventory cost = Average inventory in units* Average Inventory per unit
	Average Inventory cost =	1000 units *$12
	=	$12000
2)	D(Annual Demand)=	22500 units
	EOQ=	√2*22500*200/1.5
	=	√9000000/1.5
	=	√6000000
	EOQ=	2450 units
	Average Inventory =	EOQ/2
	=	2450 units/2
	=	1225 units
	Average Inventory cost =	1225 units *$12
	=	$14700
	Increase in Inventory=	$14700-$12000
	=	$2700

	Before Policy Change	After Police Change
Sales	$                            4,00,000	$                          6,00,000
Less Discount	$                                 1,200	$                               9,000	W.No-1
Net Sales	$                           3,98,800	$                         5,91,000
Less Cost of goods Sold-65% of net sales	$398800*65%=$259220	$591000*65%=$384150
Gross Profit	$141980	$224850
Less General & Adminstrative Expenses-15% of net sales	$398800*15%=$59820	$591000*15%=$88650
Operating Profit	$                               82,160	$                          1,36,200
Less Interst on Increase in accounts recivable and Inventory (14%)	$                                        -	$                             27,286	W.NO-2
Income Before Taxes	$                               82,160	$                          1,08,914
Less tax@40%	$                               32,864	$                             43,566
Income After Taxes	$                               49,296	$                             65,348

Working Note-1
Discount		Before Policy Change	After Police Change
	Sales	$                            4,00,000	$                          6,00,000
	Discount	01/10,net 30 discount	03/10,net 50 discount
	% of customers taking Discount	30%	50%
	Customers taking discount=Sales*% of Discount customers	$400000*30%=$120000	$600000*50%=$300000
	Discount Rate	1%	3%
	Discount=Customers taking discount*Discount rate	$120000*1%=$1200	$300000*3%=$9000
Working Note-2
Interst on Increase in accounts recivable and Inventory
	Increase in accounts Recivable =	$                            1,92,200
	Incrrease in Inventory =	$                                 2,700
	Total=Increase in accounts Recivable+Increase in Inventory	$                           1,94,900
	Interst Rate	14%
	Interst =	$                               27,286