Question 5 OR (a)
Liberalising credit: should the new policy be adopted?
10 marks
- Time to write
- About 20 minutes
From an older CBCS paper
Question
Question 5 OR (a) · 10 marksDetails of a firm's operations over a period of 12 months are below:
| Sales | Rs 15 lakhs |
| Per unit selling price | Rs.10 |
| Per unit variable cost | Rs. 7 |
| Per unit total cost | Rs. 9 |
| Credit period customers are allowed | one month |
A proposal to extend credit more liberally is being considered by the firm, which will lengthen the average collection period from one month to two months. This relaxation is expected to raise sales by 25% over their existing level. Assuming that firm's required rate of return on investment is 25%, advise the firm on adopting the new credit policy. 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
- Assuming that firm's required rate of…The paper fixes this: use it as given, and say so in your answer.
- adviseEnd with a one-line decision that follows from your figures.
What the paper leaves open
Investment in debtors is valued at total cost (C4); the extra sales carry only variable cost.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Fixed cost and units 2 marks 4 min
- 2 Investment in debtors at cost under each policy 3 marks 5 min
- 3 Extra contribution and required return 3 marks 5 min
- 4 Net gain 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 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.
Principle. A longer credit period attracts more sales but enlarges the investment in receivables, since the length of the credit period determines its size.
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.
Data. Units sold = 15,00,000 ÷ ₹10 = 1,50,000. Fixed cost = (total cost 9 − variable cost 7) × 1,50,000 = ₹3,00,000, which does not change with the sales volume. The extra sales (25%, 37,500 units) carry only variable cost; the investment in debtors is taken at total cost × collection period (paper note).
| Particulars (₹) | Present (1 month) | Proposed (2 months) |
|---|---|---|
| Units | 1,50,000 | 1,87,500 |
| Variable cost @ ₹7 | 10,50,000 | 13,12,500 |
| Fixed cost | 3,00,000 | 3,00,000 |
| Total cost | 13,50,000 | 16,12,500 |
| Investment in debtors (total cost × months ÷ 12) | 1,12,500 | 2,68,750 |
- Extra contribution = 37,500 × (10 − 7) = ₹1,12,500.
- Extra investment in debtors = 2,68,750 − 1,12,500 = ₹1,56,250; required return @ 25% = ₹39,062.50.
- Net gain = 1,12,500 − 39,062.50 = ₹73,437.50.
Advice. The incremental return on the extra funds blocked is 1,12,500 ÷ 1,56,250 = 72%, well above the required 25% (the DU text's illustration compares exactly this ratio with the required rate). The firm should adopt the new credit policy, provided bad debts do not rise significantly; none are given.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Fixed cost and units | 2 |
| 2 | Investment in debtors at cost under each policy | 3 |
| 3 | Extra contribution and required return | 3 |
| 4 | Net gain and advice | 2 |
| Total | 10 |
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