Question

Relaxation of credit standards Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 20% from 10,000 to 12,000 units during the coming year, the average collection period is expected to increase from 35 to 55 days, and bad debts are expected to increase from 1.5% to 3.5% of sales. The sale price per unit is $44, and the variable cost per unit is $33. The firm's required return on equal risk investments is 9.1%. Evaluate the proposed relaxation, and make a recommendation to the firm. (Note: Assume a 365-day year.) The additional profit contribution from an increase in sales is (Round to the nearest dollar)

Answer 1

Ans.

1. Additional profit contribution from an increase in sales:

Increase in unit sales = ( 12,000 - 10,000) = 2,000 additional units

Additional profit contribution due to increase in sales = 2,000 units * ($44-$33) = $ 22,000

2.Cost of additional investments in receivables

Turnover, proposed plan   = 365 / ACP = 365 / 55 = 6.6363 times

Turnover, Current Plan = 365/ACP = 365/35 =10.4286 times

Variable cost:   Proposed= 12,000 units * $33 = $396,000

           Current = 10,000 units * $33 = $330,000

Average investment in accounts receivable = Total Variable Cost / Accounts Receivable Turnover

Average investment (proposed plan) = $ 396,000 / 6.6363 = $ 59,671.80

Average investment (Current plan) = $ 330,000 / 10.4286 = $ 31,643.74

Marginal investment in accounts receivable   = Change in average investment

$ 59,671.80 - $ 31,643.74 = $ 28,028.06

Required return = 9.1% or 0.091

Cost of additional investment in A/R = Marginal investment × Required return

$ 28,028.06 * 0.091 = $ 2,550.55

3. Cost from increase in Bad Debts

Bad Debts (Proposed Plan) = (12,000 units * $ 44 * 0.035) = $ 18,480

Bad Debts (Current Plan) = ( 10,000 units * $ 44 * 0.015) = $ 6,600

Cost of additional Bad Debts = $ 18,480 - $ 6,600 = $ 11,880

4.The net profit or loss from implementing the proposed Plan is

Additional profit contribution from increase in sales $ 22,000

Less : Cost of additional investment in A/R..............$(2,550.55)

Less: Cost of additional Bad Debts..........................$(11,880)

Net Profit from Implementing the proposed Plan.....$ 7,569.45

According to the evaluation of the proposed relaxation, it would be in the company's interest to adopt the proposed relaxation plan as it will leads to net profit of $ 7,569.45.