Question

ABC Ltd. has revenue of N$500 million and sells all of its goods on credit to a variety of different wholesale customers. At the moment the company offers a standard credit period of 30 days. However, 70% of its customers (by revenue) take an average of 70 days to pay, while the other 30% of customers (by revenue) pay within 30 days. The company is considering offering a 2% discount for payment within 30 days and estimates that 80% of customers (by revenue) will take up this offer (including those that already pay within 30 days).
The Managing Director has asked the credit controller if the cost of this new policy would be worth offering. The company has a £80 million overdraft facility that it regularly uses to the full limit due to the lateness of payment and the cost of this overdraft facility is 15% per annum.
The credit controller also estimates that bad debt level of 2% of revenue would be halved to 1% of revenue as a result of this new policy.
Required

1. Calculate the approximate equivalent annual percentage cost of a discount of 2%, which reduces the time taken by credit customers to pay from 70 days to 30 days.

2. Calculate the value of trade receivables under the existing scheme and the proposed scheme at the year-end.                 (8 marks

3. Evaluate the benefits and costs of the scheme and explain with reasons whether the company should go ahead and offer the discount. You should also consider other factors in this decision. (Hint: You need to work out the cost of the discount compared to the interest on the overdraft saved and bad debt reduction.)                    

Answer 1

Note that I take 1 year as 365 days. And that this problem can be done in 2 ways as regards calculation is concerned, both leading to same results. And a differing approach can be taken, which can lead to different values for annual percentage cost.

1. Equivalent Annual Percentage Cost
[This can be interpreted differently, and the answer may change depending upon the interpretation. I use one approach. If you are taught another approach, make mention of the method and I will re-work accordingly]

Interest Costs under Proposed scheme [Note 3]	N$            7.8082	(in millions)
Discount [Note 3]	N$              8.0000	(in millions)
(-) Interest Costs under existing scheme	N$             11.9178	(in millions)
Costs associated [i.e., 7.8082+8 - 11.9178]	N$              3.8904	(in millions)
Advance Received [i.e., Debtors of (58-38) days [See Note 1 also]	N$            27.3973	(in millions
Equivalent Annual Percentage Cost [3.8904 / 27.3973]	14.20%	(rounded)

Note (again): The above percentage can change depending upon the approach used.

2. Trade Receivables under each scheme

Trade Receivables under Existing Scheme [i.e., Average Collection Period x N$500 million / 365] See Note 1 also	N$            79.4521	(in millions) (rounded)
Trade Receivables under Proposed Scheme [i.e., Average Collection Period x N$500 million / 365] [See Note 1 also]	N$            52.0548	(in millions) (rounded)

3. Evaluation

Benefits
Savings in interest costs
Existing Interest Cost [Note 2]	N$            11.9178
Proposed Scheme Interest Cost [Note 3]	N$               7.8082
Total Difference	N$               4.1096
Savings in Bad Debt
Existing Bad Debt [Note 2]	N$            10.0000
Proposed Scheme Bad Debt [Note 3]	N$               5.0000
Total Difference	N$               5.0000
Costs
Discount	N$               8.0000
Net Benefits [4.1096 + 5 - 8]	N$               1.1096

As it leads to a net benefit, it is advised to proceed with the proposed scheme. Other factors to consider are any possibility in getting bank overdraft interest changed to our favor, considering factoring arrangements, etc.

NOTES:

Note 1: Basic Data
Annual Sales	N$          500.0000	(in millions)
Existing Average Collection Period	58 days	[30 days x 30% + 70 days x 70%]
Proposed Average Collection Period	38 days	[30 days x 80% + 70 days x 20%]
Note 2: Existing Costs
Bad Debt of 2% of Sales	N$            10.0000	(in millions)
Interest Costs on Funds blocked, i.e., 58 days x $500 million / 365 days x 15%	N$            11.9178	(in millions) (rounded)
Total	N$            21.9178	(in millions)
Note 3: Costs in the Proposed System
Bad Debt of 1% of Sales	N$               5.0000
Interest Costs on Funds blocked, i.e., 38 days x $500 million / 365 days x 15%	N$               7.8082	(in millions) (rounded)
Discount @ 2% of 80% of Sales	N$               8.0000	(in millions)
	N$           20.8082	(in millions)