Chapter 10 - Accounts Receivable and Inventory Management
An Example of the Trade-off
Suppose that a firm’s product sells for $10 a unit, of which $8 represents variable costs before
taxes, including credit department costs. The firm is operating at less than full capacity, and an
increase in sales can be accommodated without any increase in fixed costs. Currently, annual
credit sales are running at a level of $2.4 million, and there is no underlying growth trend in
such credit sales. The firm may liberalize credit, which will result in an average collection
period of two months for new customers. Existing customers are not expected to alter their
payment habits. The relaxation in credit standards is expected to produce a 25 percent
increase in sales, to $3 million annually. Finally, assume that the firm’s opportunity cost of
carrying the additional receivables is 20 percent before taxes. The increased investment arises
solely from new, slower-paying customers. We have assumed that existing customers will
continue to pay in 1 month.
P = $10
VC = $8
Annual credit sales = $2,400,000
Annual credit sales (NEW) = $3,000,000
Average collection period for new customers = 2 months
Receivable turnover for new customers =12/2 =6
the contribution margin per unit for each additional unit sold = $10 − $8 = $2
Additional units sold = ($3,000,000 - $2,400,000) / $10
= $600,000/ $10
= 60,000 units
Profitability of additional sales
= (Contribution margin per unit) × (Additional units sold)
= $2 × 60,000 units
= $120,000
Additional receivables
= (Additional sales revenue)/(Receivable turnover for new customers)
= $600,000/6 = $100,000
Investment in additional receivables
=(Variable cost per unit/Sales price per unit) × (Additional receivables)
=($8/$10) × $100,000
=$80,000
Required before-tax return on additional investment
= (Opportunity cost) × (Investment in additional receivables)
= 0.20 × $80,000 = $16,000
Therefore,
Profitability of additional sales = $120,000
Required return on additional investment in receivables = $16,000
$120,000 > $16,000
The firm would be well advised to relax its credit standards.
EXAMPLE: Credit Period
Let us say that the firm in our example changes its credit terms from “net 30” to “net 60” –
thus increasing its credit period from 30 to 60 days. The more liberal credit period results in
increased sales of $360,000, and these new customers also pay, on average, in two months.
The total additional receivables are composed of two parts. The first part represents the
receivables associated with the increased sales. In our example, there is $360,000 in
additional sales. The second part of the total additional receivables is caused by the slowing in
collections associated with sales to original customers. Receivables due to original customers
are now collected in a slower manner resulting in a higher receivable level.
Additional units sold = $360,000/$10
= 36.000 units
Old receivable turnover = 12/1
=12
New receivable turnover = 12/2
=6
Profitability of additional sales
= (Contribution margin per unit) × (Additional units sold)
= $2 × 36,000 units
= $72,000
Additional receivables associated with new sales
= (New sales revenue)/(New receivable turnover)
=$360,000/6 = $60,000
Investment in additional receivables associated with new sales
= (Variable cost per unit/Sales price per unit) × (Additional receivables)
=0.80 × $60,000 = $48,000
Level of receivables before credit period change
= (Annual credit sales)/(Old receivable turnover)
= $2,400,000/12 = $200,000
New level of receivables associated with original sales
= (Annual credit sales)/(New receivable turnover)
=$2,400,000/6 = $400,000
Investment in additional receivables associated with original sales
= $400,000 − $200,000 = $200,000
Total investment in additional receivables
= $48,000 + $200,000 = $248,000
Required before-tax return on additional investment
= (Opportunity cost) × (Total investment in additional receivables)
=0.20 × $248,000
= $49,600
Therefore,
Profitability of additional sales = $72,000
Required return on additional investment in receivables = $49,600
$72,000> $49,600
The firm would be well advised to relax its credit standards. The change in credit period from
30 to 60 days is worthwhile.
EXAMPLE: Cash Discount Period
Suppose that the firm has annual credit sales of $3 million and an average collection period of
two months. Also, assume that sales terms are “net 45,” with no cash discount given. By
initiating terms of “2/10, net 45,” the average collection period can be reduced to one month,
as 60 percent of the customers (in dollar volume) take advantage of the 2 percent discount.
The turnover of receivables has improved to 12 times a year.
Consequently, the average receivables balance is $3,000,000/6 = $500,000.
The opportunity cost of the discount to the firm is 0.02 × 0.6 × $3 million, or $36,000
annually.
The turnover of receivables has improved to 12 times a year, so that average receivables are
reduced from $500,000 to $250,000 (i.e., $3,000,000/12 = $250,000).
Thus, the firm realizes $250,000 from accelerated collections. The value of the funds released
is their opportunity cost. If we assume a 20 percent before-tax rate of return, the opportunity
saving is $50,000.
Level of receivables before cash discount change
= (Annual credit sales) / (Old receivable turnover)
$3,000,000/6 = $500,000
New level of receivables associated with cash discount change
= (Annual credit sales) / (New receivable turnover)
$3,000,000/12 = $250,000
Reduction of investment in accounts receivable
= (Old receivable level) − (New receivable level)
$500,000 − $250,000 = $250,000
Before-tax cost of cash discount change
= (Cash discount) × (Percentage taking discount) × (Annual credit sales)
= 0.02 × 0.60 × $3,000,000
= $36,000
Before-tax opportunity savings on reduction in receivables
= (Opportunity cost) × (Reduction in receivables)
= 0.20 × $250,000 = $50,000
Therefore,
In this case the opportunity savings arising from a speed-up in collections are greater than the
cost of the discount.
$50,000>$36,000
The firm should adopt a 2 percent discount.