Fashion Distributors Incorporated currently sells on terms of 2/10, net 30, with bad debt losses at 1% of
gross sales. Of the 99% of the customers that pay, 50% take the discount and pay on Day l0; the remaining
50% pay on Day 30 (average collection period of 20 days).
FDI's gross sales are currenly $2 million per year, with variable costs amounting to 75oz of sales. The firm
finances its receivables with a 10% line of credit, and there are sufficient fixed assets to support a doubling
in sales.
FDI's credit manager has proposed that credit terms be changed to 2/10, net 50. It is estimated that these
terms will boost sales to $2.75 million per year. However, bad debt loss€s will double to 2% of the new
sales level. It is expected that 50% of the paying customers will continue to take the discount and pay on
Day 10, and the other 50% will pay on Day 50.
REQUIRED:
a) What is the new average collection period?
b) Should the change in credit terms b€ made? Justify your answer and show all relevant calculations,
as well as any assumptions necessary.
To answer these questions, we'll need to calculate the new average collection period and determine whether the change in credit terms should be made. Let's start by calculating the new average collection period:
a) New Average Collection Period:
The average collection period is the average number of days it takes for customers to pay their invoices. In this scenario, we have two payment terms: 10 days for customers who take the discount and 50 days for customers who don't. We need to calculate the weighted average of these two payment periods, considering the percentage of customers in each group.
Weighted Average Collection Period = (Percentage of customers taking the discount * Payment period for customers taking the discount) + (Percentage of customers not taking the discount * Payment period for customers not taking the discount)
Percentage of customers taking the discount = 50%
Percentage of customers not taking the discount = 50%
Payment period for customers taking the discount = 10 days
Payment period for customers not taking the discount = 50 days
Weighted Average Collection Period = (0.50 * 10) + (0.50 * 50)
Weighted Average Collection Period = 5 + 25
Weighted Average Collection Period = 30 days
Therefore, the new average collection period would be 30 days.
b) Should the change in credit terms be made?
To determine whether the change in credit terms should be made, we need to consider the impact on sales and bad debt losses. Let's calculate the annual sales and bad debt losses under the new credit terms:
Old Gross Sales = $2 million per year
New Gross Sales = $2.75 million per year
Bad Debt Losses (Old) = 1% of gross sales = 0.01 * $2 million = $20,000
Bad Debt Losses (New) = 2% of new gross sales = 0.02 * $2.75 million = $55,000
Next, we need to calculate the additional interest expense resulting from the increase in accounts receivable due to the extended credit terms. Given that the line of credit interest rate is 10%, we can calculate the additional interest expense:
Additional Interest Expense = (Increase in Accounts Receivable) * (Line of Credit Interest Rate)
Increase in Accounts Receivable = (Percentage of customers not taking the discount) * (New Gross Sales)
Percentage of customers not taking the discount = 50%
New Gross Sales = $2.75 million
Increase in Accounts Receivable = 0.50 * $2.75 million = $1.375 million
Additional Interest Expense = $1.375 million * 0.10 = $137,500
Now, let's calculate the total costs associated with the change in credit terms:
Additional Bad Debt Losses = Bad Debt Losses (New) - Bad Debt Losses (Old) = $55,000 - $20,000 = $35,000
Total Costs = Additional Bad Debt Losses + Additional Interest Expense
Total Costs = $35,000 + $137,500 = $172,500
Finally, we compare the total costs to the increase in gross profits resulting from the increase in sales:
Increase in Gross Profits = New Gross Sales - Old Gross Sales = $2.75 million - $2 million = $750,000
If the total costs are less than the increase in gross profits, it would be financially beneficial to make the change in credit terms. If the total costs are greater than the increase in gross profits, it may not be advisable to make the change.
In this case, the total costs ($172,500) are less than the increase in gross profits ($750,000), indicating that the change in credit terms should be made.