Question 5 OR (b)
Should the credit period be doubled?
9 marks
- Time to write
- About 18 minutes
Question
Question 5 OR (b) · 9 marksA company sells goods at ₹10 per unit, with a variable cost of ₹4 and fixed cost of ₹6,00,000 per year. Its present annual sales are ₹30,00,000. If the credit period is doubled from one month to two months and this raises sales by ₹2,40,000 annually, and the company requires a pre-tax return of 20%, should the policy change be implemented? Support your answer with calculations.
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
- calculationsFormula first, then the working, then the answer with its unit (₹, %, units).
- should theEnd with a one-line decision that follows from your figures.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Units, contribution and total cost 3 marks 5 min
- 2 Investment in debtors at cost 3 marks 5 min
- 3 Incremental return, net benefit and decision 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 18 minutes for 9 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 longer credit period raises sales and contribution but ties up more funds in debtors, measured at cost. The change is worthwhile if the extra contribution, as a return on the extra funds blocked, exceeds the required 20% before tax; the net benefit is shown as a check. No change in fixed costs or bad debts is given.
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.
| ₹ | Present (1 month) | Proposed (2 months) |
|---|---|---|
| Sales | 30,00,000 | 32,40,000 |
| Units (÷ ₹10) | 3,00,000 | 3,24,000 |
| Contribution (₹6 a unit) | 18,00,000 | 19,44,000 |
| Variable cost (₹4 a unit) | 12,00,000 | 12,96,000 |
| Fixed cost | 6,00,000 | 6,00,000 |
| Total cost | 18,00,000 | 18,96,000 |
| Average debtors at cost (total cost × months ÷ 12) | 1,50,000 | 3,16,000 |
| ₹ | |
|---|---|
| Increase in contribution | 1,44,000 |
| Extra funds blocked in debtors | 1,66,000 |
| Incremental return (1,44,000 ÷ 1,66,000) | 86.75% |
| Required return on extra funds (20% × 1,66,000) | 33,200 |
| Net benefit | 1,10,800 |
Decision. The extra contribution earns 86.75% on the additional funds tied up, far above the 20% required; a policy whose expected rate of return on the extra investment exceeds the required rate is the one to adopt. It leaves a net gain of ₹1,10,800 a year after charging the required return on the debtors held at cost. The policy change should be implemented.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Units, contribution and total cost | 3 |
| 2 | Investment in debtors at cost | 3 |
| 3 | Incremental return, net benefit and decision | 3 |
| Total | 9 |
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