Question 4 (b)
Choice of credit policy
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 4 (b) · 11 marksA company's annual sale is Rs. 12 lakhs, and its average collection period is 45 days. It is considering a shift in its credit policy. This information is available:
Variable cost is 60% of sales, and Fixed cost is Rs. 2 lakhs per annum, with current bad debts at 1%. The Required return on investment is 20%.
The estimates for the different credit policies are:
| Credit policy | Average Collection Period | Sales increase | Bad debts |
|---|---|---|---|
| A | 60 days | Rs 60,000 | 2% |
| B | 75 days | Rs 96,000 | 3% |
| C | 85 days | Rs 1,20,000 | 4% |
Determine the credit policy the company should adopt.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- estimatesFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The return on investment is applied to the investment in debtors at cost (variable cost plus fixed cost), as in FM convention C4. Fixed cost does not change with the policy.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Sales, costs and bad debts under each policy 4 marks 8 min
- 2 Investment in debtors at cost and the required return 4 marks 7 min
- 3 Net benefit under each policy 2 marks 4 min
- 4 Decision 1 mark 1 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Short on time? End with step 4's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Method. A more liberal credit policy raises sales but also bad debts and the funds blocked in debtors. The policy to choose is the one with the highest profit after charging the required return on the investment in debtors, the investment being taken at cost (variable plus fixed cost) × collection period ÷ 360 (paper note). The length of the credit period and the discount determine the size of the investment in receivables.
1'Pay next month'—the boxes fly off the van and every arm in the lane is full.
Consequences of lengthening the credit periodHigher sales and profit; larger investment in receivables; more bad debts and collection costs.
2Cash on delivery only: fewer takers at the door, but the money is in hand today.
Consequences of shortening the credit periodLower investment in receivables and better liquidity; possible loss of sales and profit.
Evaluation of the credit policies (₹)
| Particulars | Present | A | B | C |
|---|---|---|---|---|
| Sales | 12,00,000 | 12,60,000 | 12,96,000 | 13,20,000 |
| Variable cost (60%) | 7,20,000 | 7,56,000 | 7,77,600 | 7,92,000 |
| Fixed cost | 2,00,000 | 2,00,000 | 2,00,000 | 2,00,000 |
| Total cost | 9,20,000 | 9,56,000 | 9,77,600 | 9,92,000 |
| Bad debts (1%, 2%, 3%, 4%) | 12,000 | 25,200 | 38,880 | 52,800 |
| Profit (sales − total cost − bad debts) | 2,68,000 | 2,78,800 | 2,79,520 | 2,75,200 |
| Collection period (days) | 45 | 60 | 75 | 85 |
| Investment in debtors at cost (total cost × days ÷ 360) | 1,15,000 | 1,59,333.33 | 2,03,666.67 | 2,34,222.22 |
| Required return @ 20% | 23,000 | 31,866.67 | 40,733.33 | 46,844.44 |
| Net benefit | 2,45,000 | 2,46,933.33 | 2,38,786.67 | 2,28,355.56 |
Decision. Policy A (60 days) gives the highest net benefit, ₹2,46,933.33, which is ₹1,933.33 more than the present policy; policies B and C give less than the present one, because their extra bad debts and the cost of the extra funds tied up exceed the extra contribution. The company should adopt credit policy A.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Sales, costs and bad debts under each policy | 4 |
| 2 | Investment in debtors at cost and the required return | 4 |
| 3 | Net benefit under each policy | 2 |
| 4 | Decision | 1 |
| Total | 11 |
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