Question

Over the last few years, specialty coffee shops have expanded in the east coast due to the influence
that the presence of Starbucks has had on coffee trends. In an effort to boost sales, the credit department at Silverston Coffee Merchants, a wholesaler of specialty imported coffee beans, has approved credit sales to cafés that have not had a long operating history. Silverston has enjoyed an impressive growth in revenue to $400 million. However, bad debt expense has increased from 3% to 6% of sales. Silverston knows that not all the new cafes will survive, but as the competition diminishes, the few remaining shops will have a dominant market share and will be profitable.

The finance department would like to adopt a new credit policy which would reduce credit sales, resulting in an overall sales reduction of 8%, but a decrease in bad debt expense to 2.6% of sales. The company has an operating profit margin of 38%, before bad debt expense and other costs associated with the credit policy. If it adopts the stricter credit policy, the company’s average collection period would decrease from 50 days to 40 days. The company’s financing rate of 6% will remain the

same. Implementing the new credit policy would require $500,000 in additional annual overhead costs.

1. Should Silverston implement the new credit policy? Write a recommendation to the company in the form of a memo clearly explaining your position.

   Calculate the following to support your recommendation:

   1. What is EBT now with the existing credit policy? Show your calculations

   2. What will EBT be with the new credit policy? Show your calculations.

2. Suggest 2 other factors that the company should consider, other than the savings in bad debt

   expense, in implementing the new credit policy.

Answer 1

CUSTOMER CREDIT POLICY ANALYIS

We are asked under this question to evaluate and recommend on new credit policy. For this analysis we need to understand incremental profit earned if new policy is implemented: -

Lets first calculate EBT under old credit policy: -

Sr. No.	Particulars	Amount ($)
1	Sales	400
2	Operating expenses	248
3	Operating profit	152
	Less:
	Bad debts	24
4	Operating Profit	128
5	Financing Cost	3.29
6	EBT	124.71

NOTES: -

1. Sales figure is mentoned in question

2. Operating expenses are 62% of salesvalue

3. Bad debts expenses calculated as 6% of total sales ($400)

4. Financing cost is incurred on cost of operations and therefore 3.29 cost is calcualated on entire credit sales of $400 for 50 days on further assumption of 365 days in year (400 x 6% x 365)

Now, lets calculate EBT under new credit policy: -

Sr. No.	Particulars	Amount ($)
1	Sales	368
2	Operating expenses	228.16
3	Operating profit	139.84
	Less:
	Bad debts	9.57
4	Operating Profit	130.272
5	Financing Cost	2.42
6	Additional cost	0.50
6	EBT	127.35

Notes-

1. Sales will fall by 8% and therefore calculated as 92% of 368

2. Bad debts calculated at2.6% of 368.

3. Financing cost calculated as 368 x 6% x 40/ 365

CONCLUSION: -Therefore, Company will make an incremental profit of $ 2.64 with new credit policy and therefore it should adopt new credit policy.

Other factors which should be paid attention while adopting new credit policy : -

1. Additional cost of $0.5M per year. Management should evaluate this cost nature. If this cost goes on increasing every year, it may eventually lead to incremental loss as with the change of credit policy only $2.64 EBT increased. If company is focusing on bed debts reduction, it can go for factoring its debtors who will assure fixed payments(non-recourse factoring) while charging a commission.

2. Profit margin: - Company should pay attention to its operating profit margin. With the implementation of new credit policy it loss $32 sales and $12.16 operating profit thereon. Net margin(EBT) increased with new credit policy but loss of 12.16 contribution also matters. Instead, company should go for boosting its sales by offering discounts for processing early payments. Reducing customer base is not an acceptable fact. Reducing credit period will adversly affect customers, clients who may eventually start looking for better options with earlier credit period of 509 days.