Daud Tools, a manufacturer of lathe tools, is currently selling a product for $10 per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per unit is $6. The firm’s total fixed costs are $120,000.

The firm is currently contemplating a relaxation of credit standards that is expected to result in the following; a 5% increase in unit sales to 63,000 units; an increase in average collection period from 30 days (the current level) to 45 days; an increase in bad debt expenses from 1% of sales (current level) to 2%. The firm determines that its cost of tying

up funds in receivables is 15% before taxes.

Question: Determine whether it would be profitable for Daud Tools to relax its credit standards. To arrive at your decision, show the calculation of;

a. Additional profit contribution from sales

b. Cost of marginal investment in account receivables

C. Cost of marginal investment in bad debts

# SOLUTION

## Evaluating Profitability of Relaxed Credit Standards for Daud Tools

Here’s a breakdown to determine if relaxing credit standards is profitable:

**a. Additional profit contribution from sales:**

- Calculate the current contribution margin per unit: Selling Price ($10) – Variable Cost ($6) = $4 per unit
- Calculate the additional unit sales: 63,000 units (new) – 60,000 units (old) = 3,000 units
- Multiply the additional unit sales by the contribution margin per unit: 3,000 units * $4/unit = $12,000

**b. Cost of marginal investment in account receivables:**

- Calculate the current average daily sales: 60,000 units / 365 days = $164.39 (rounded to two decimals)
- Calculate the increase in average collection period: 45 days (new) – 30 days (old) = 15 days
- Multiply the increase in collection period by the average daily sales: 15 days * $164.39/day = $2,465.85 (rounded to two decimals)
- Multiply the additional unit sales by the increase in average collection period: 3,000 units * $2,465.85/unit = $7,397.55 (rounded to two decimals)
- Calculate the cost of tying up funds as a decimal: 15% / 100 = 0.15
- Multiply the cost of tying up funds by the increase in investment in receivables: $7,397.55 * 0.15 = $1,109.63 (rounded to two decimals)

**c. Cost of marginal investment in bad debts:**

- Calculate the current bad debt expense: 1% of Sales * $600,000 Sales = $6,000
- Calculate the increase in bad debt percentage: 2% (new) – 1% (old) = 1%
- Multiply the increase in bad debt percentage by the new sales amount: 1% * $630,000 (new sales) = $6,300
- Subtract the current bad debt expense from the new bad debt expense: $6,300 – $6,000 = $300

**Profitability Analysis:**

Compare the additional profit contribution from sales with the combined cost of marginal investments:

- Additional Profit Contribution: $12,000
- Cost of Marginal Investment (Receivables): $1,109.63
- Cost of Marginal Investment (Bad Debts): $300
**Total Additional Cost:**$1,409.63

**Conclusion:**

Since the additional profit contribution from sales ($12,000) is greater than the combined additional cost ($1,409.63), relaxing the credit standards would be **profitable** for Daud Tools in this scenario. They would gain an additional $10,590.37 ($12,000 – $1,409.63).