Question 4 OR (b)
Extending the credit period: should it be done?
10 marks
- Time to write
- About 20 minutes
From an older CBCS paper
Question
Question 4 OR (b) · 10 marksRTL ltd wishes to raise its current annual sales of Rs. 36,00,000. The product's selling price is Rs.300 per unit and its variable cost Rs.200 per unit, and its fixed cost is Rs.3,60,000 per year. It now offers its customers a credit period of one month, and 1% of the sales at present become unrecoverable.
It is estimated that sales can be increased by 15% if the company extends the credit period to 2 months, but such a change in its credit policy will raise the bad debts to 3%. Given that it's minimum required rate of return is 20%, advise the company whether the proposed credit policy should be implemented. (5,10)
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
- adviseEnd with a one-line decision that follows from your figures.
What the paper leaves open
"It's minimum required rate of return" is kept as printed. Investment in debtors is valued at total cost (variable plus fixed), as in convention C4.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Sales, costs and bad debts under each policy 3 marks 5 min
- 2 Investment in debtors at cost and required return 4 marks 7 min
- 3 Net benefit and advice 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 3's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 20 minutes for 10 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. The investment in debtors is valued at total cost (variable plus fixed) × credit period (paper note). A longer credit period raises sales but also bad debts and the funds blocked in receivables. Present sales 36,00,000 ÷ ₹300 = 12,000 units; proposed 15% more = 13,800 units (₹41,40,000).
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 (1 month) | Proposed (2 months) |
|---|---|---|
| Sales | 36,00,000 | 41,40,000 |
| Variable cost (₹200 a unit) | 24,00,000 | 27,60,000 |
| Fixed cost | 3,60,000 | 3,60,000 |
| Total cost | 27,60,000 | 31,20,000 |
| Bad debts (1% / 3%) | 36,000 | 1,24,200 |
| Profit (sales − total cost − bad debts) | 8,04,000 | 8,95,800 |
| Investment in debtors at cost (total cost × months ÷ 12) | 2,30,000 | 5,20,000 |
| Required return @ 20% | 46,000 | 1,04,000 |
| Net benefit | 7,58,000 | 7,91,800 |
Advice. The proposed policy raises the net benefit by ₹33,800: the extra contribution of ₹1,80,000 exceeds the extra bad debts (₹88,200) and the 20% return on the extra ₹2,90,000 tied up in debtors (₹58,000). The proposed credit policy should be implemented.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Sales, costs and bad debts under each policy | 3 |
| 2 | Investment in debtors at cost and required return | 4 |
| 3 | Net benefit and advice | 3 |
| Total | 10 |
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