The firm's collection policy may affect also our study. The higher the cost of collecting accounts obtainable the lower the bad debt losses. Therefore the firm must consider if the reduction in bad debt is extra than the increase in collection costs.
As saturation point improved expenditure in collection efforts does not conclude in reduced bad debt and hence the firm must not spend more after reaching this point.
Riffruff Ltd is assuming relaxing its credit standards. The firm's current credit terms are net 30 but the average debtor's collection period is 45 days. Current annual credit sales amounts to of Sh.6, 000,000. The firm wants to extend credit duration net 60. Sales are expected to increase by 20 percent. Bad debts will rise from 2 percent to 2.5 percent of annual credit sales. Credit analysis and debt collection costs will increase with Sh.4, 000 p.a. The return on investment in debtors is 12 percent for of Sh.100 of sales, of Sh.75 are variable costs. Suppose 360 days p.a. Should the firm transform the credit policy?
Current sales = Sh.6, 000,000
New sales = Sh.6, 000,000 x 1.20 = Sh.7,200,000
Contribution margin = Sh.100 - Sh.75 = Sh.25
Therefore contribution margin ratio = (Sh.25/Sh.100)* 100 = 25%
Cost advantage analysis
New policy 25% x 7,200,000 = 1,800
Current policy 25% x 6,000,000 = 1,500 = 300
Credit analysis and debt collection costs (84)
New bad debts = 2.5% x 7,200,000 = 180
Current bad debts = 2% x 6,000,000 = 120 (60)
New debtors = Cr.period/360 days x cr. Sales p.a.
= (60/360) * 7,200,000
Current debtors = (45/360) * 6, 00,000
Increase in debtors (tied up capital) 450
Forgone profits = 12% x 450 (54)
Net benefit (cost) 102
Hence, change the credit policy.