Question

The new credit manager of Kay’s Department Store plans to liberalize the firm’s credit policy. The firm currently generates credit sales of $575,000 annually. The more lenient credit policy is expected to produce credit sales of $750,000. The bad debt losses on the additional sales are projected to be 5%, despite an additional $15,000 collection expense. The new manager anticipates production and selling costs will remain at the 85% level. The firm’s opportunity cost is 12%.

1. If the firm maintains its receivables turnover of 10 times, should the credit policy be changed?
2. Assume additional inventory of $35,000 is required to support the additional sales, should Kay’s Department store proceed with the more lenient credit policy?

Answer 1

a)	S/N	Details	Under Present Credit Policy (in USD)	Under revised Credit Policy (in USD)
	a)	Credit Sales	5,75,000	7,50,000
	b)	Less : Production & Selling Cost at 85% Level of sales	4,88,750	6,37,500
	c)	Additional Collection expenses on account of additional sales - under revised Credit Policy	0	15,000
	d)	Bad Debt losses on additional sales - 5% : Since in the instant case, additional sales owing to revised credit policy would be amounted to USD 1,75,000 (750000-575000). Bad Debt losses would be 5% on USD 175000	0	8,750
	e)	Opportunity Cost(explained in annexure 1 detailed below)	6,900	9,000
	Net Benefit	79,350	79,750
	Annexure 1
	Cash Loss owing to liberal credit policy	Under Present Credit Policy	Under revised Credit Policy
	Debtor Turnover Ratio	10	10
	Credit Sales	5,75,000	7,50,000
	Debtor	57,500	75,000
	Opportunity Cost	12%	12%
	Opportunity Cost (in value) due to blockage of fund lies with the debtors	6,900	9,000

In view of the above, as it is clear that Net Benefit under liberised credit policy is more than USD 400 than present policy, it is more prudent to change the current credit policy.

b) In case company would be required to bring additional inventory of USD 35,000, then there would be blocakge of funds which results in loss of oppoertunity cost for the company. The details calculation is shown below;

1) Additinional Inventory USD 35,000/-

2)Opportunity Cost would be USD 35,000 * 12% = USD 4200

3) Additional Net Benfit under liberal credit policy would be USD 400 (see part (a)). However, if additional stock/inventory is required to support the additional cost then company would entail additional opportunity cost of USD 4200, resulting in it would be loss of (USD 400 - USD 4200) = USD 3800.

In view of the above analysis,as company would incur additional loss of USD 3800, company should not change present credit policy.

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