Question

Bilbo Bags & Things makes fashionable handbags. They are considering extending trade credit to some customers previously considered poor risks. The following estimations are made for this new customer base:

• Sales would increase by $100,000 if credit is extended to these new customers.
• Production and selling costs will be 80% of sales.
• All sales will be on credit, and 10% of them will prove to be uncollectible.
• Additional collection costs will be 5% of sales, and
• Customer Service costs will be 3% of Sales.
• The firm is in the 20 percent tax bracket.

What is the incremental income after taxes?

a). 2,000

b). 80,000

c). 1,600

d). 100,000

Answer 1

Option (c) is correct

For calculating incremental income, we will take each item on incremental (increase) basis.

Incremental sales = $100000

Incremental production & selling costs = 80% of incremental sales = 80% * $100000 = $80000

Incremental gross margin = Incremental sales - Incremental production & selling costs

Incremental gross margin = $100000 - $80000 = $20000

Now, we will deduct each incremental cost from the incremental gross margin to arrive at incremental income after taxes

Incremental bad debts = 10% of incremental sales = 10% * $100000 = $10000

Incremental collection costs = 5% of incremental sales = 5% * $100000 = $5000

Incremental customer service cost = 3% of incremental sales = 3% * $100000 = $3000

Incremental income before tax = Incremental gross margin - Incremental bad debts - Incremental collection costs - Incremental customer service cost

Incremental income before tax = $20000 - $10000 - $5000 - $3000 = $2000

Income tax = 20% = 20% * $2000 = $400

Incremental income after tax = Incremental income before tax - income tax

Incremental income after tax = $2000 - $400 = $1600