Question

Power Play Inc. has seen profits drop acutely because of the economic downturn. To enhance profitability and to preserve cash, Power Play is considering shortening its credit period and eliminating its cash discount. Terms are currently 3/10, net 60 and would be changed to net 30. Currently, 60 percent of customers, on average, pay at the end of the credit period (60 days); the other 40 percent pay, on average, in 10 days and receive the discount. It is anticipated that under the new policy customers will pay, on average, in 30 days. At present, average monthly sales are $450,000, but they are expected to fall to $400,000 with the tightening of credit. Variable production costs are 78 percent, and bank financing is currently floating at 11 percent. Bad debt losses at 2 percent of sales are expected to drop to 1.75 percent of sales.

a. Should Power Play’s credit policy be tightened?

• Yes

• No

b. What is the average accounts receivable balance under both policies? (Use 365 days in a year. Round the final answers to nearest whole dollar.)

Present policy	$
New policy	$

Answer 1

a.

	Present Policy	New Policy
Sales	$               450,000	$       400,000
Costs
Variable Production Costs	$               351,000	$       312,000
Bad Debt losses	$                   9,000	$           7,000
Discount	$                   5,400
Opportunity Cost	$                   2,441
Total Costs	$               367,841	$       319,000
Net Operating Income	$                 82,159	$         81,000

No, Power Play’s credit policy should not be tightened, since Net Operating Income under Present policy is higher due to higher sales

b.
Present Policy
Average Accounts Receivables in days = 10 x 40% + 60 x 60% = 40 days
Average Accounts Receivable = $450000 x12 x 40/365 = $591781

New Policy
Average Accounts Receivable = $400000 x 12 x 30/365 = $394521

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