Question 4 (b)
Choosing a credit policy
12 marks
- Time to write
- About 24 minutes
Question
Question 4 (b) · 12 marksOjas Ltd. is considering a change in its present credit policy. The details of the options are as follows:
| Credit Policy | Present | A | B | C |
|---|---|---|---|---|
| Sales (₹) | 60,000 | 67,200 | 72,000 | 74,400 |
| Variable cost (80%) (₹) | 48,000 | 53,760 | 57,600 | 59,520 |
| Fixed cost (₹) | 19,200 | 19,200 | 19,200 | 19,200 |
| Average collection period(days) | 30 | 45 | 60 | 75 |
If the rate of investment is 20%, advise the best option.
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
"Rate of investment" is read as the required rate of return on the investment in receivables.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Contribution and total cost under each policy 3 marks 5 min
- 2 Average investment in debtors at cost 3 marks 5 min
- 3 Incremental return on extra funds against 20% 3 marks 5 min
- 4 Net-benefit check and advice policy B 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 4's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 24 minutes for 12 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 longer collection period raises sales and contribution but blocks more funds in debtors. The funds blocked are measured at cost: average debtors = total cost × collection period ÷ 360. A move to a longer period is worth making if the incremental contribution ÷ extra funds blocked exceeds the required return of 20%. As a check, each policy's net benefit is its profit less the required return on its investment in debtors.
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.
1. Contribution, cost and investment in debtors
| ₹ | Present | A | B | C |
|---|---|---|---|---|
| Sales | 60,000 | 67,200 | 72,000 | 74,400 |
| Variable cost (80%) | 48,000 | 53,760 | 57,600 | 59,520 |
| Contribution | 12,000 | 13,440 | 14,400 | 14,880 |
| Fixed cost | 19,200 | 19,200 | 19,200 | 19,200 |
| Total cost | 67,200 | 72,960 | 76,800 | 78,720 |
| Collection period (days) | 30 | 45 | 60 | 75 |
| Average debtors at cost (total cost × days ÷ 360) | 5,600 | 9,120 | 12,800 | 16,400 |
2. Incremental return on the extra funds blocked
| Move | Increase in contribution (₹) | Extra funds in debtors (₹) | Incremental return | Against 20% |
|---|---|---|---|---|
| Present → A | 1,440 | 3,520 | 40.91% | worth it |
| A → B | 960 | 3,680 | 26.09% | worth it |
| B → C | 480 | 3,600 | 13.33% | not worth it |
Moving to A and then to B earns more than 20% on the extra funds; moving on to C earns only 13.33%.
3. Check: net benefit of each policy
| ₹ | Present | A | B | C |
|---|---|---|---|---|
| Profit (contribution − fixed cost) | (7,200) | (5,760) | (4,800) | (4,320) |
| Less: 20% on average debtors | 1,120 | 1,824 | 2,560 | 3,280 |
| Net benefit | (8,320) | (7,584) | (7,360) | (7,600) |
Advice. Adopt policy B (60 days' collection period). It gives the best net result and is the last extension whose incremental return exceeds 20%. Note that fixed costs exceed contribution under every policy, so the firm makes a loss whichever it chooses; policy B keeps that shortfall, after the cost of the funds tied up in debtors, at its lowest.
Where the 12 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Contribution and total cost under each policy | 3 |
| 2 | Average investment in debtors at cost | 3 |
| 3 | Incremental return on extra funds against 20% | 3 |
| 4 | Net-benefit check and advice (policy B) | 3 |
| Total | 12 |
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