Question

Chapter 6 Case 37

Valley Clothing is a small clothing retailer now in its fourth year of business. Through its first year of operations, Valley has operated on a pure cash or check basis. Currently, Valley has averaged $275,000 in annual cash sales with an average profit margin of 40%. Lately, many customers have expressed frustration over the fact that Valley does not accept credit sales, and Valley believes that this is beginning to have a substantial negative impact on the business. Valley is contemplating two plans of action, neither of which will impact the company's current cash sales.

Plan 1

Offer qualified customers the opportunity to purchase merchandise on account. Valley believes this will create new credit sales of 18% of current cash sales. Increased expenses would include 4% of net credit sales related to bad debts, 2% of net credit sales for billing, and 1% of net credit sales for increased recordkeeping.

Plan 2

Begin accepting credit cards. Valley believes this will create new credit sales of 23% of current cash sales. Increased expenses would include 5.5% of net credit sales-related credit card fees and 0.5% of net credit sales for increased recordkeeping.

Compute net income under each plan assuming a tax rate of 30%. Which plan would you recommend Valley accept? What other factors should Valley consider when evaluating these options?

Answer 1

	Plan1
Credit Sales (18% of Cash Sales)	49,500.00
Existing Profit Margin ( 40%)	19,800.00
Bad-Debt(4%*49,500)	1,980.00
Incremental Billing Expenses(2%*49,500)	990.00
Incremental Recordkeeping expenses(1%*49,500)	495.00
Net Income Before Tax	16,335.00
Tax (30%)	4,900.50
Net Income After Tax	11,434.50

	Plan2
Credit Sales (23 % of Cash Sales)	63,250.00
Existing Profit Margin ( 40%)	25,300.00
Credit Card Fees(5.5%*63,250)	3,478.75
Incremental Recordkeeping expenses(0.5%*63,250)	316.25
Net Income Before Tax	21,505.00
Tax (30%)	6,451.50
Net Income After Tax	15,053.50

Plan 2 is is better as Net Margin is more in case of Plan 2.

In Business, the customer relationship is important so we should start the credit card sales for the convenience of Customers. We will get extra sales without risk of bad-debts.