2. Example 5
Super Sports, dealing in sports goods, has an annual sale of Rs 50 lakh and
currently extending 30 days’ credit to the dealers. It is felt that sales can pick
up considerably if the dealers are willing to carry increased stocks, but the
dealers have difficulty in financing their inventory. The firm is, therefore,
considering shifts in credit policy. The following information is available:
The average collection period now is 30 days.
Variable costs, 80 per cent of sales.
Fixed costs, Rs 6 lakh per annum
Required (pre-tax) return on investment: 20 per cent
Credit policy Average collection period
(days)
Annual sales (Rs lakh)
A 45 56
B 60 60
C 75 62
D 90 63
Determine which policy the company should adopt.
3. Solution
Evaluation of Proposed Credit Policies (Amount in Rupees lakh)
Particulars Present Proposed (number of days)
(30) A(45) B(60) C(75) D(90)
(a) Sales revenue
Less: Variable costs (80% of sales)
Total contribution
Less: Fixed costs
Profit
Increase in profits due to increase
in total contribution (20% of sales)
compared to present profits
(b) Investment in debtors:
Total cost (VC + FC)
Debtors turnover (DT) (360 days
collection period)
Average investment (total cost ÷ DT)
Additional investment compared to
present level
Cost of additional investment
(c) Incremental profit (a – b)
50
40
10
6
4
—
46
12
3.83
—
—
—
56
44.8
11.2
6
5.2
1.2
50.8
8
6.35
2.52
0.50
0.70
60
48
12
6
6
2
54
6
9
5.17
1.03
0.97
62
49.6
12.4
6
6.4
2.4
55.6
4.8
11.58
7.75
1.55
0.85
63
50.4
12.6
6
6.6
2.6
56.4
4
14.10
10.27
2.05
0.55
Policy B (average collection period 60 days) should be adopted as it yields maximum
profit.
