Question 5 (b)
Stricter credit policy: should it be implemented?
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 5 (b) · 11 marksJKL Limited is considering making its present credit policy a little stricter. The company's current annual sales are ₹ 72,00,000, and implementing the proposed credit policy is expected to bring the annual sales down to ₹ 57,60,000. The average collection period would fall from 60 days to 45 days. The product's sale price is ₹ 40, and the variable cost of manufacturing a product is ₹ 30. At a volume of 1,80,000 units, average cost works out to ₹ 34. Take a year as comprising 360 days. If the firm's required rate of return is 25%, give advice on whether the proposed strict credit policy should be implemented. 11
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
- adviceEnd with a one-line decision that follows from your figures.
What the paper leaves open
Investment in debtors is valued at cost (variable cost plus fixed cost), as in FM convention C4.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Fixed cost from the average cost 2 marks 4 min
- 2 Sales, costs and profit under each policy 3 marks 5 min
- 3 Investment in debtors at cost and required return 4 marks 7 min
- 4 Net benefit and advice 2 marks 4 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.
Fixed cost. At 1,80,000 units the average cost is ₹34 and the variable cost ₹30, so fixed cost = (34 − 30) × 1,80,000 = ₹7,20,000, unchanged by the policy: operating fixed cost does not change with the sales volume. The investment in debtors is taken at cost, total cost × collection period ÷ 360 (paper note).
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.
| Particulars | Present policy | Proposed (stricter) policy |
|---|---|---|
| Sales | 72,00,000 | 57,60,000 |
| Variable cost (₹30 a unit) | 54,00,000 | 43,20,000 |
| Fixed cost | 7,20,000 | 7,20,000 |
| Total cost | 61,20,000 | 50,40,000 |
| Profit (sales − total cost) | 10,80,000 | 7,20,000 |
| Collection period (days) | 60 | 45 |
| Investment in debtors at cost (total cost × days ÷ 360) | 10,20,000 | 6,30,000 |
| Required return @ 25% | 2,55,000 | 1,57,500 |
| Net benefit | 8,25,000 | 5,62,500 |
Advice. The stricter policy releases ₹3,90,000 from debtors, worth ₹97,500 a year at 25%, but loses ₹3,60,000 of contribution on the lower sales (36,000 units × ₹10). The net benefit falls by ₹2,62,500, so the proposed stricter credit policy should not be implemented. A tighter credit policy improves liquidity, but here at too high a cost in sales.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Fixed cost from the average cost | 2 |
| 2 | Sales, costs and profit under each policy | 3 |
| 3 | Investment in debtors at cost and required return | 4 |
| 4 | Net benefit and advice | 2 |
| Total | 11 |
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