BigBlue Prints has sales this year of $15 million under its current credit polic

Question

BigBlue Prints has sales this year of $15 million under its current credit policy. The present terms are net 30; the average collection period is 60 days; and the bad debt loss percentage is 5 percent. Also, BigBlue’s opportunity cost is 15 percent, and its variable costs total 30 percent of sales. Since BigBlue wants to improve its profitability, a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $600,000, and that 50 percent of credit customers would take the discount. The new average collection period would be 45 days, and the bad debt loss percentage on credit sales would fall to 4 percent. Perform a complete analysis to justify whether or not the proposed changes in credit terms should be implemented.

Explanation / Answer

Costs:

Discount cost = Discount rate * credit sales = 2% * 15.6 = $312,000

Gains:

Find what are receivables in both case

Account receivables = Sales / Receivables turnover

Case 1 = Sales * Receivable days / 360 = 15 * 60 / 360 = $2.5 million

Case 2 = Sales * Receivable days / 360 = 15.6 * 45 / 360 = $1.95 million

The firm realizes 2.5 - 1.95 = 550,000 from accelerated sales

Opportunity savings = 550,000 * 15% = 82,500

Bad debt reduction profit = 5% * 15 - 4% * 15.6 = 126,000

Profit from net income increase = 600000 * (1-30%) = 420,000

So Discounts cost incurred by company (312,000) are lower than realized gain (126,000 + 82,500 + 420,000 = 628,500)

Hence proposed changes increases company value. Company should change its credit terms

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