Question

Use the following information on Black Red to answer questions 14 – 18.

JDL is considering whether to discontinue offering credit to customers who currently have late payments on the credit extended to them. Current annual credit sales are $10 million and such a change in policy is expected to reduce sales by 15 percent, cut the firm’s bad-debt losses from 8 to 4 percent, and reduce average collection period from 70 days to 45 days. The firm’s variable cost ratio is 0.80 and its required pretax return on receivables and inventory investments is 25 percent. Because of the anticipated decrease in sales, the company expects its inventories to decrease by $200,000.

Determine the lost profit contribution due to this credit-tightening policy (because sales have decreased).

Determine the benefit of less investment in accounts receivable.

Determine the benefit of less bad-debt loss.

Determine the benefit of less investment in inventory.

Determine the net change in pretax profits due to this policy tightening.

Answer 1

1. Calculation of lost profit contribution due to credit-tightening policy:

Previous Sales = $ 10,000,000

Reduction in Sales = 10,000,000 x 15 % = $ 1,500,000

Variable cost Ratio = 0.80

Contribution Ratio = 1-0.80 = 0.20

Lost Profit Contribution = Reduction in Sales x Contribution Ratio = $ 1,500,000 x 0.20 = $ 300,000

2. Benefit of less investment in accounts receivable:

Average Collection period = Average accounts receivable/ Total Credit Sales x 365

Previousl Collection period = 70 = Average accounts receivable/ 10,000,000 x 365

Average Accounts Receivable (Previously) = 70 x 10,000,000 / 365 = $ 1,917,808.21

New Sales = 10,000,000 - 1,500,000 = 8,500,000

New Collection period = 45 = Average accounts receivable/ 8,500,000 x 365

Average Accounts Receivable (New) = 45 x 8,500,000 / 365 = $ 1,047,945.21

Benefit of less investment in accounts receivable due to new policy =$ 1,917,808.21 - $ 1,047,945.21 =$ 869,863

3. Benefit of less bad debts:

Total Bad Debts before policy = Average accounts receivable x Bad Debt percentage = $ 1,917,808.21 x 8%

= $ 153,424.66

Total Bad Debts before policy = $ 1,047,945.21 x 4 % = $ 41,917.81

Benefit of reduced Bad Debt Loss = $ 153,424.66 - $ 41,917.81 = $ 111,506.85

4. Benefit of less investment in inventory = $ 200,000 x 25% = $ 50,000

5. Net Change in pre-tax profit due to credit-tightening policy:

Net-change in pre-tax profit = $ 1,846,575.34 - $ 1,708,082.19 = $ 138,493.15