Question 5 OR (b)
Doubling the credit period
12 marks
- Time to write
- About 24 minutes
Question
Question 5 OR (b) · 12 marksA company sells a product at Rs. 300 per unit, its variable cost being Rs. 200 per unit. Its fixed cost is Rs. 7,50,000 per annum and its total annual sales are Rs. 90,00,000. The company gives its customers one month's credit. It is estimated that if the present credit period of one month is doubled to two months, sales will reach Rs. 97,20,000 annually. The company expects a return of at least 20% on investment, before taxation. Justify by calculation that this change in policy benefits the company.
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
- at least 20The question sets a minimum: give 20 or more.
- estimatedFormula 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 Units, contribution and total cost under each policy 4 marks 7 min
- 2 Average investment in debtors at cost 4 marks 7 min
- 3 Incremental return, net benefit and conclusion 4 marks 6 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 3's one-line conclusion, 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. Doubling the credit period raises sales and contribution but ties up more funds in debtors. The funds are measured at cost; the change pays if the extra contribution, as a return on the extra funds blocked, exceeds the required 20%. Net benefit after the required return 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 | 90,00,000 | 97,20,000 |
| Units (÷ ₹300) | 30,000 | 32,400 |
| Contribution (₹100 a unit) | 30,00,000 | 32,40,000 |
| Variable cost (₹200 a unit) | 60,00,000 | 64,80,000 |
| Fixed cost | 7,50,000 | 7,50,000 |
| Total cost | 67,50,000 | 72,30,000 |
| Average debtors at cost (total cost × months ÷ 12) | 5,62,500 | 12,05,000 |
| ₹ | |
|---|---|
| Increase in contribution | 2,40,000 |
| Extra funds blocked in debtors (12,05,000 − 5,62,500) | 6,42,500 |
| Incremental return (2,40,000 ÷ 6,42,500) | 37.35% |
| Required return on extra funds (20% × 6,42,500) | 1,28,500 |
| Net benefit | 1,11,500 |
Conclusion. The extra contribution earns 37.35% on the additional funds tied up in debtors, more than the 20% required, leaving a net gain of ₹1,11,500 a year. The change to a two-month credit period benefits the company.
Where the 12 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Units, contribution and total cost under each policy | 4 |
| 2 | Average investment in debtors at cost | 4 |
| 3 | Incremental return, net benefit and conclusion | 4 |
| Total | 12 |
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