Question 5 OR (a)
Should the relaxed credit policy be adopted?
12 marks
- Time to write
- About 24 minutes
Question
Question 5 OR (a) · 12 marksKaveri Limited believes it can increase sales by relaxing its credit terms. Its profit plan under the existing credit terms projects sales of ₹24,00,000, a profit-volume ratio of 30%, fixed costs of ₹1,20,000, bad debts of 1%, and an accounts receivable turnover ratio of 10 times.
With the relaxed credit policy, sales are expected to go up to ₹28,80,000. The bad debts, however, are projected to rise to 2% of sales, while the accounts receivable turnover ratio is expected to fall to 6 times.
The company must determine whether to adopt the new (relaxed) credit policy, given a target rate of return of 20%. Assume 360 days in a year.
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
- Assume 360 days in a yearThe paper fixes this: use it as given, and say so in your answer.
- determineFormula first, then the working, then the answer with its unit (₹, %, units).
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Contribution, bad debts and profit under each policy 4 marks 7 min
- 2 Average investment in debtors at cost 4 marks 7 min
- 3 Incremental return and net benefit; decision 4 marks 6 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 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. The relaxed policy raises contribution but also bad debts and the funds tied up in debtors. The funds are measured at cost; the move is worthwhile if the incremental profit, as a return on the extra funds blocked, exceeds the 20% target. Net benefit after the required return is shown as a check. Fixed costs are taken as unchanged.
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. Profit and investment in debtors
| ₹ | Present policy | Relaxed policy |
|---|---|---|
| Sales | 24,00,000 | 28,80,000 |
| Contribution (P/V 30%) | 7,20,000 | 8,64,000 |
| Less: fixed costs | 1,20,000 | 1,20,000 |
| Less: bad debts (1%; 2%) | 24,000 | 57,600 |
| Profit | 5,76,000 | 6,86,400 |
| Variable cost (70% of sales) | 16,80,000 | 20,16,000 |
| Fixed costs | 1,20,000 | 1,20,000 |
| Total cost | 18,00,000 | 21,36,000 |
| Debtors turnover (times); collection period (360 ÷ turnover) | 10; 36 days | 6; 60 days |
| Average debtors at cost (total cost ÷ turnover) | 1,80,000 | 3,56,000 |
| ₹ | |
|---|---|
| Incremental profit (6,86,400 − 5,76,000) | 1,10,400 |
| Extra funds blocked in debtors (3,56,000 − 1,80,000) | 1,76,000 |
| Incremental return (1,10,400 ÷ 1,76,000) | 62.73% |
| Required return on extra funds (20% × 1,76,000) | 35,200 |
| Net benefit (1,10,400 − 35,200) | 75,200 |
Decision. The relaxed policy earns 62.73% on the extra funds it ties up, well above the 20% target, and leaves a net benefit of ₹75,200 a year. Kaveri Limited should adopt the relaxed credit policy.
Where the 12 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Contribution, bad debts and profit under each policy | 4 |
| 2 | Average investment in debtors at cost | 4 |
| 3 | Incremental return and net benefit; decision | 4 |
| Total | 12 |
Report a problemopens an email to admin@getkunji.com with the question ID7357-Q5ORaalready filled in.