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A company with $4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase credit sales by $720,000. The company's average collection period for new customers is expected to be 75 days; and the payment behavior of the existing customers is not expected to change.
Variable costs are 80 percent of sales. The firm's opportunity cost is 20 percent before taxes. Assuming a 360-day year, what is the company's benefit (loss) on the planned change in credit terms?
Choice 'c' is correct. $120,000 benefit on the planned change in credit standards.
This question pertains to the economic benefit associated with a change in credit terms.
The question tells us that the credit sales will increase by $720,000 if we relax our credit terms. We know variable costs are 80%, so we will earn $144,000 as a result of the expanded sales. The 20% contribution margin is equal to the 20% opportunity cost so there is no better investment of our resources for the expanded credit sales relative to its margin.
What about the variable costs, though?
We have $576,000 in variable costs that will be outstanding, pro rata, 75 days of the year. So the resources we will use to produce our sales is 75/360ths of $576,000, or $120,000 at any given time during the year. These $120,000 in resources could earn 20% annual return or $24,000. The $24,000 opportunity cost, compared to the $144,000 margin results in a $120,000 benefit in relaxing credit terms.
Choices 'a', 'b', and 'd' are incorrect, per the above calculation/discussion.