The Widget Company is considering a change in it’s credit standards. The company

ID: 2805643 • Letter: T

Question

The Widget Company is considering a change in it’s credit standards. The company sells currently 15 000 units of Widgets. The sales price is 32€. The variable cost is 75% of the sales price. The relaxation of the credit standards should result in 15% sales increase. However, the average credit collection period increases to 60 days from current 20 days. It is also expected that bad debt loss would also increase from 1% to 3% of the sales. The company finances its current assets with short-term loans that carry 10% of interest.

Try to evaluate if a change in credit standards has a positive effect on the profits of the company or not. In order to do so, you will have to compare additional profits with increase in bad debt expense and financing costs of additional receivables.

Explanation / Answer

Let’s see impact of relaxation of the credit standards on the net profit of Widget Company;

Current case

Change in credit standards

Sale

480000

552000

Variable costs

(360000)

(414000)

Gross margin

120000

138000

Interest expense @ 10%

(2667)

(9200)

Bad debts

(4800)

(16560)

Net profits

112533

112240

Thus on the basis of above comparative study it is clear that due to an increase of bad debt expense net profit will be low in compare to current case. That is why it is clear that a change in credit standards has a negative effect on the profits of the company. There are two reasons for negative impact on net profits;

1. Increased interest expenses.

2. Increased burden of bad debts.

Working Note;

1. Interest is calculate as follow;

(480000 * .10 * 20 / 360) = 2667 (Approx.)

(552000 * .10 * 60 / 360) = 9200

2. Bad debts expenses is calculate as follow;

(480000 * .01) = 4800

(552000 * .03) = 16560