Example of Relaxing Credit Standards
Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their credit standards will improve profitability.
•The firm is currently producing a single product with variable costs of $20 and selling price of $25.
•Relaxing credit standards is not expected to affect current customer payment habits.
•Additional annual credit sales of $120,000 and an average collection period for new accounts of 3 months is expected.
•The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 18%.
Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit standards?
Profitability of ($5 contribution) x (4,800 units) =
additional sales$24,000
(120,000/25 = 4,800 units)
Additional ($120,000 sales) / (4 Turns) =
receivables$30,000
(120,000/(3/12) = 30,000)
Investment in ($20/$25) x ($30,000) =
add. receivables$24,000
Req. pre-tax return (18% opp. cost) x $24,000 =
on add. investment$4,320
(18% of additional investment)
Yes! Profits > Required pre-tax return
Example of Relaxing the Credit Period
Basket Wonders is considering changing its credit period from “net 30” (which has resulted in 12 A/R “Turns” per year) to “net 60” (which is expected to result in 6 A/R “Turns” per year).
•The firm is currently producing a single product with variable costs of $20 and a selling price of $25.
•Additional annual credit sales of $250,000 from new customers are forecasted, in addition to the current $2 million in annual credit sales
•The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax its credit period?
Profitability of ($5 contribution)x(10,000 units) =
additional sales$50,000
(250,000/25 = 10,000)
Additional ($250,000 sales) / (6 Turns) =
receivables$41,667
Investment in add.($20/$25) x ($41,667) =
receivables (new sales)$33,334
Previous($2,000,000 sales) / (12 Turns) =
receivable level$166,667
New($2,000,000 sales) / (6 Turns) =
receivable level$333,333
Investment in $333,333 - $166,667 =
add. receivables$166,666
(original sales)
Total investment in $33,334 + $166,666 =
add. receivables$200,000
Req. pre-tax return (20% opp. cost) x $200,000 =
on add. investment$40,000
Yes! Profits > Required pre-tax return
Changing credit standards
uLi Hong Company is currently selling a product for $10 per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per unit is $6. The firm’s total fixed costs are $120,000.
uThe firm is considering a relaxation of credit standards that is expected to result in the following: a 5% increase in unit sales to 63,000 units; an increase in the average collection period from 30 days (its current level) to 45 days; an increase in bad-debt expenses from 1% of sales (the current level) to 2%. The firm’s required return on equal-risk investments, which is the opportunity cost of tying up funds in accounts receivable, is 15%.
uNeed to calculate the effect on the firm’s additional profit contribution from sales, the cost of the marginal investment in accounts receivable and the cost of marginal bad debts.
uAdditional profit contribution from sales
uFixed costs are ‘sunk’ and thereby unaffected by a change in the sales level.
uVariable cost is the only cost relevant to a change in sales. Sales are expected to increase by 5%, or 3,000 units. The profit contribution per unit equals the difference between the sale price per unit ($10) and the variable cost per unit ($6) and so the profit contribution per unit will be $4.
uThus, the total additional profit contribution from sales will be $12,000 (3,000 units × $4 per unit).
Cost of the marginal investment in accounts receivable
uTo determine the cost of the marginal investment in accounts receivable, Li Hong must find the difference between the cost of carrying receivables before and after the introduction of the relaxed credit standards. We are only concerned about the out-of-pocket costs so the relevant cost in this analysis is the variable cost.
uThe average investment in accounts receivable can be calculated using the following formula:
uAverage investment in accounts receivable = total variable cost of annual sales/ turnover of accounts receivable
uWhereTurnover of accounts receivable = 365/average collection period
uThe total variable cost of annual sales, using the variable cost per unit of $6 are,
Total variable cost of annual sales:
uUnder present plan: ($6 × 60,000 units) = $360,000
uUnder proposed plan: ($6 × 63,000 units) = $378,000
uThe proposed plan increases total variable cost of sales by $18,000.
uThe turnover of accounts receivable shows the number of times each year that accounts receivable are turned into cash. It is found by dividing the average collection period into 365.
Turnover of accounts receivable (rounded):
uUnder present plan: 365/30 = 12.2
uUnder proposed plan: 365/45 = 8.1
uSubstitute the cost and turnover data just calculated to get the following average investments in accounts receivable:
Average investment in accounts receivable:
uUnder present plan: $360,000/12.2 = $29,508
uUnder proposed plan: $378,000/8.1 = $46,667
The marginal investment in accounts receivable, and its cost, are calculated as follows:
Cost of marginal investment in accounts receivable (A/R):
uAverage investment under proposed plan$46,667
u– Average investment under present plan 29,508
uMarginal investment in accounts receivable $17,159
u× Required return on investment 0.15
uCost of marginal investment in A/R $2,574
uThe value of $2,574 is a cost because it represents the maximum amount that could have been earned on the $17,159 had it been placed in the best equal-risk investment alternative available at the firm’s required return on investment of 15%.
Cost of marginal bad debts
uThe cost of marginal bad debts is the difference between the level of bad debts before and the level of bad debts after the change in credit standards:
Cost of marginal bad debts:
uUnder proposed plan: 0.02 × $10 × 63,000 units = 12,600
uUnder present plan: 0.01 × $10 × 60,000 units = 6,000
uCost of marginal bad debts $6,600
uBad debts costs are calculated by using the sale price per unit ($10) to identify not just the true loss of variable (or out-of-pocket) cost ($6) that results when a customer fails to pay its account, but also the profit contribution per unit—in this case, $4 ($10 sales prices – $6 variable cost)—that is included in the ‘additional profit contribution from sales’. Thus, the resulting cost of marginal bad debts is $6,600.
uTo decide whether the firm should relax its credit standards, the additional profit contribution from sales must be compared with the sum of the cost of the marginal investment in accounts receivable and the cost of marginal bad debts. If the additional profit contribution is greater than marginal costs, credit standards should be relaxed.
uThe effect of Li Hong’s credit relaxation policy:
Credit Terms
uLi Hong Company has an average collection period of 40 days (turnover = 365/40 = 9.1). The firm’s credit terms are net 30, so this period is divided into 32 days until the customers place their payments in the mail (not everyone pays within 30 days) and 8 days to receive, process and collect payments once they are mailed. Li Hong is considering changing its credit terms from net 30 to 2/10 net 30. This change is expected to reduce the amount of time until the payments are placed in the mail, resulting in an average collection period of 25 days (turnover = 365/25 = 14.6).
uAs shown in the EOQ example (slide 74), Li Hong has a raw material with current annual usage of 1,100 units. Each finished product produced requires one unit of this raw material at a variable cost of $1,500 per unit, incurs another $800 of variable cost in the production process and sells for $3,000 on terms of net 30. Li Hong estimates that 80% of its customers will take the 2% discount and that offering the discount will increase sales of the finished product by 50 units (from 1,100 to 1,150 units) per year but will not alter its bad-debt percentage. Li Hong’s opportunity cost of funds invested in accounts receivable is 14%. Should Li Hong offer the proposed cash discount?
uAnalysis of initiating a cash discount for Li Hong Company
uLi Hong’s opportunity cost of funds is 14%
Example of Introducing a Cash Discount
A competing firm of Basket Wonders is considering changing the credit period from “net 60” (which has resulted in 6 A/R “Turns” per year) to “2/10, net 60.”
•Current annual credit sales of $5 million are expected to be maintained.
•The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R “Turns” to 8.
•(30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days
•360 days per year / 45 days = 8 turns per year
•The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise, should the competing firm introduce a cash discount?
Receivable level ($5,000,000 sales) / (6 Turns) =
(Original)$833,333
Receivable level ($5,000,000 sales) / (8 Turns) =
(New)$625,000
Reduction of $833,333 - $625,000 =
investment in A/R$208,333
Pre-tax cost of 0.02 x 0.3 x $5,000,000 =
the cash discount $30,000.
Pre-tax opp. savings(20% opp. cost) x $208,333 =
on reduction in A/R$41,667.
Yes! Savings > Costs
Textbook p.251
An Example of the Trade-off.
To assess the profitability of an extension ofcredit, we must know the profitability of additional sales, the added demand for productsarising from the relaxed credit standards, the increased length ofthe average collection period,and the required return on investment. Suppose that a firm's product sells for $10 a unit, ofwhich $8 represents variable costs before taxes. The firmis operating at less than full capacity, and an increase in sales can be accommodated withoutany increase in fixed costs. Therefore the contribution margin per unit for each additionalunit sold is the selling price less variable costs involved in producing an additional unit, or$10-$8=$2.
Currently, annual credit sales are $2.4 million. The firm may liberalise credit, which will result inan average collection period of two months for new customers. Existing customers are notexpected to alter their payment habits. The relaxation in credit standards is expected to producea 25 percent increase in sales, to $3 million annually. The $600,000 increase represents60,000 additional units if the price per unit stays the same. Finally, assume thatthe firm's opportunity cost of carrying the additional receivables is 20 percent before taxes.
This information reduces our evaluation to a trade-off between the added expected profitability on the additional sales and the opportunity cost of the increased investment in receivables. The increased investment arises solely from new, slower-paying customers. We have assumed that existing customers continue to pay in 1 month. With additional sales of
$600,000 and a receivable turnover of six times a year for new customers (12 months divided by the average collection period of 2 months), the additional receivables are $600,000/6 = $100,000. For these additional receivables, the firm invests the variable costs tied up in them.
For our example, $0.80 of every $l in sales represents variable costs. Therefore the added investment in receivables is 0.80 x $100,000 = $80,000. With these inputs, we are able to make the calculations shown in Table 10.1. Inasmuch as the profitability on additional sales,
$2 x 60,000 = $120,000, far exceeds the required return on the additional investment in receivables, 0.20 x $80,000 = $16,000, the firm would be well advised to relax its credit standards. An optimal policy would involve extending credit more liberally until the marginal profitability on additional sales equals the required return on the additional investment in receivables necessary to generate those sales. However, as we take on poorer credit risks, we also increase the risk of the firm, as reflected in the variance of the firm's expected cash-flow stream. This increase in risk also manifests itself in additional bad-debt losses, a subject we deal with shortly.
Present
PolicyPolicy APolicy B
Demand $2,400,000 $3,000,000 $3,300,000
Incremental sales $ 600,000 $ 300,000
Default losses
Original sales 2%
Incremental Sales 10% 18%
Avg. Collection Pd.
Original sales1 month
Incremental Sales12 times2 months 3 months
per year6 times4 times
Policy APolicy B
1. Additional sales$600,000 $300,000
2. Profitability: (20% contribution) x (1) 120,000 60,000
3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000
4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000
5. Invest in add. receivables: (.80) x (4) 80,000 60,000
6. Required before-tax return on
additional investment: (5) x (20%) 16,000 12,000
7. Additional bad-debt losses +
additional required return: (3) + (6) 76,000 66,000
8. Incremental profitability: (2) - (7) 44,000 (6,000)
Adopt Policy A but not Policy B.
Example of the Economic Order Quantity
Basket Wonders is attempting to determine the economic order quantity for fabric used in the production of baskets.
•10,000 yards of fabric were used at a constant rate last period.
•Each order represents an ordering cost of $200.
•Carrying costs are $1 per yard over the 100-day planning period.
What is the economic order quantity?
We will solve for the economic order quantity given that ordering costs are $200 per order, total usage over the period was 10,000 units, and carrying costs are $1 per yard (unit).
Q*=√[2(o)(s)]/c
Q* = √[2 x 200 x 10,000]/1
=2,000 units
Example of When to Order
Julie Miller of Basket Wonders has determined that it takes only 2 days to receive the order of fabric after the placement of the order.
When should Julie order more fabric?
Lead time = 2 days
Daily usage = 10,000 yards / 100 days = 100 yards per day
Order Point= 2 days x 100 yards per day= 200 yards
Safety Stock – Inventory stock held in reserve as a cushion against uncertain demand (or usage) and replenishment lead time.
Our previous example assumed certain demand and lead time. When demand and/or lead time are uncertain, then the order point is:
Order Point = (Avg. lead time x Avg. daily usage) + Safety stock
EOQ and JIT example
uLi Hong Company has an A group inventory item that is vital to the production process. This item costs $1,500, and Li Hong uses 1,100 units of the item per year. Li Hong wants to determine its optimal order strategy for the item. To calculate the EOQ, we need the following inputs:
uOrder cost per order = $150
uCarrying cost per unit per year = $200
uSubstituting into EOQ Equation, we get
uEOQ =√(2 × 1,100 × $150)/200
u≈ 41 units
uThe reorder point depends on the number of days Li Hong operates per year. Assuming that he operates 250 days per year and uses 1,100 units of this item, its daily usage is 4.4 units (1,100 / 250).
uIf its lead time is two days and Li Hong wants to maintain a safety stock of four units, the reorder point for this item is 12.8 units ((2 × 4.4) + 4). However, orders are made only in whole units, so the order is placed when the inventory falls to 13 units.
uNow assume the same information as before, but assume that the marginal cost of placing an order is (i) $11 or (ii) $2.
u1 Order cost of $11
uEOQ = √(2 × 1,100 × $11)/200
u= √121 = 11 units
u2 Order cost of $2
uEOQ = √(2 × 1,100 × $2)/200
u= √22 = 5 units