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:

1. Calculate the current contribution margin per unit: Selling Price ($10) – Variable Cost ($6) = $4 per unit
2. Calculate the additional unit sales: 63,000 units (new) – 60,000 units (old) = 3,000 units
3. 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:

1. Calculate the current average daily sales: 60,000 units / 365 days = $164.39 (rounded to two decimals)
2. Calculate the increase in average collection period: 45 days (new) – 30 days (old) = 15 days
3. Multiply the increase in collection period by the average daily sales: 15 days * $164.39/day = $2,465.85 (rounded to two decimals)
4. 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)
5. Calculate the cost of tying up funds as a decimal: 15% / 100 = 0.15
6. 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:

1. Calculate the current bad debt expense: 1% of Sales * $600,000 Sales = $6,000
2. Calculate the increase in bad debt percentage: 2% (new) – 1% (old) = 1%
3. Multiply the increase in bad debt percentage by the new sales amount: 1% * $630,000 (new sales) = $6,300
4. 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).