1. Kevin’s Supply has a reputation with its competitors and customers as the fir

Question

1. Kevin’s Supply has a reputation with its competitors and customers as the firm with the toughest credit standards in the industry. Kevin’s high credit standards have resulted in the firm requiring cash on delivery from about 40% of its potential customers. Because of these high standards, many of the potential customers decide to deal with other suppliers who are more lenient in granting credit. Kevin’s has just hired a new CEO who has decided to challenge the firm’s existing credit standards. She estimates that by granting credit to the average risk customers, sales will increase by $4.8 million. The CEO expects 25% of the new credit customers to take advantage of Kevin’s 2% discount, and 5% of the new sales to become bad-debt losses. The average collection period for this category of customers is expected to be 51 days. The CEO estimates that an additional inventory investment of $1 million will be necessary due to the expected sales increase. The CEO has stipulated that any investment in current assets provide a 14% pre-tax return. If the firm’s variable cost ratio is 85%, should the average risk customers be extended credit?

Explanation / Answer

Statement Showing Incremental Profit (Loss)   Due to New Credit Policy Particulars Amount Additional Sales $              4,800,000 Less: Variable Costs (85% of Sales) $              4,080,000 Less: Additional Trade Discount $                    24,000 ($4.80 Million X 25% X 2%) Less: Increased in Bad Debts $                 240,000 ($4.80 Million X 5%) Less: Interest in Increases Inventory Investment $19,561.64 ($1 Million X 14% X (51 Ddys / 365 Days)) Incremantal Profit / (Loss) $           436,438.36 Company should adopt the credit policy, as it will increased their profit by $436438.36

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