Collection policy, Finance Basics

Collection Policy

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.

Demonstration

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?

Suggested Solution

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

Contribution Margin

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)

Bad debts

New bad debts       =        2.5% x 7,200,000          =          180

Current bad debts   =      2% x 6,000,000             =           120                  (60)

Debtors

New debtors        = Cr.period/360 days x cr. Sales p.a.

                          =        (60/360) * 7,200,000  

                           =        1,200

Current debtors    =        (45/360) * 6, 00,000   

                         =           750

Increase in debtors (tied up capital)                     450

Forgone profits    =        12% x 450                     (54)

Net benefit (cost)                                             102

Hence, change the credit policy.

Posted Date: 1/31/2013 8:19:59 AM | Location : United States







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