FF has an annual credit sales of $250,000 units with an average collection period of 70 days. The company has a per unit variable cost of $20 and a per unit sale price of $30. Bad debts currently are 5% of sales. The firm estimates that a proposed relaxation of credit would not affect its 70 day average collection period but would increase bad debts to 7.5% of sales, which would increase to $300,000 units per year. FF requires a 12% return on investments. Show all calculations required to evaluate FF's proposed relation of credit standards.
I cannot find how to calculate and what is needed or required
To evaluate FF's proposed relaxation of credit standards, we need to compare the current and proposed scenarios in terms of profitability and overall return on investment.
1. First, let's calculate the current situation:
- Annual credit sales: $250,000 units
- Per unit variable cost: $20
- Per unit sale price: $30
- Bad debts: 5% of sales (0.05)
- Collection period: 70 days
a. Calculate the contribution margin per unit:
Contribution margin = Sale Price - Variable Cost
Contribution margin = $30 - $20 = $10
b. Calculate the annual contribution margin:
Annual contribution margin = Contribution margin per unit x Annual sales
Annual contribution margin = $10 x 250,000 = $2,500,000
c. Calculate the accounts receivable balance (credit sales x collection period):
Accounts receivable balance = Annual credit sales x Collection period / 365
Accounts receivable balance = $250,000 x 70 / 365 = $47,945.21
d. Calculate the bad debts expense:
Bad debts expense = Credit sales x Bad debts percentage
Bad debts expense = $250,000 x 0.05 = $12,500
e. Calculate the net annual contribution margin after accounting for bad debts:
Net annual contribution margin = Annual contribution margin - Bad debts expense
Net annual contribution margin = $2,500,000 - $12,500 = $2,487,500
f. Calculate the net investment in accounts receivable (Accounts receivable balance x (1 + Return on investment rate)):
Net investment in accounts receivable = Accounts receivable balance x (1 + Return on investment rate)
Net investment in accounts receivable = $47,945.21 x (1 + 0.12) = $53,747.07
2. Now, let's calculate the proposed situation:
- Annual credit sales: $300,000 units
- Bad debts: 7.5% of sales (0.075)
a. Calculate the annual contribution margin:
Annual contribution margin = Contribution margin per unit x Annual sales
Annual contribution margin = $10 x 300,000 = $3,000,000
b. Calculate the bad debts expense:
Bad debts expense = Credit sales x Bad debts percentage
Bad debts expense = $300,000 x 0.075 = $22,500
c. Calculate the net annual contribution margin after accounting for bad debts:
Net annual contribution margin = Annual contribution margin - Bad debts expense
Net annual contribution margin = $3,000,000 - $22,500 = $2,977,500
d. Calculate the net investment in accounts receivable (including the proposed credit relaxation):
Net investment in accounts receivable = Accounts receivable balance x (1 + Return on investment rate)
Net investment in accounts receivable = $47,945.21 x (1 + 0.12) = $53,747.07
3. Finally, let's evaluate the proposed relaxation of credit standards:
To evaluate the proposed relaxation, we compare the net annual contribution margin and the net investment in accounts receivable between the current and proposed scenarios.
In this case, both the net annual contribution margin and the net investment in accounts receivable remain the same in the proposed scenario. Therefore, the proposed relaxation of credit standards would not affect FF's profitability or return on investment.