Revenue cycle: practice problem

Maggie's Gold Coins, Inc. is considering shortening its credit period from 30 days to 20 days and believes, as a result of this change, its average collection period will decrease from 36 days to 30 days. Bad debt expenses are also expected to decrease from 1.2 percent to 0.8 percent of sales. The firm is currently selling 300,000 units but believes as a result of the change, sales will decline to 275,000 units. On 300,000 units, sales revenue is $4,200,000, variable costs total $3,300,000, and fixed costs are $300,000. The firm has a required return on similar-risk investments of 15 percent. Evaluate this proposed change and make a recommendation to the firm.

Decline in sales = [300,000 – 275,000] = 25,000 units

Selling price = [$42,00,000 / 300,000 units] = $14

Variable cost per unit = [$3300,000 / 300,000 units] = $11

Reduction in profit contribution margin from decline in sales= [300,000 – 275,000 units] X [$14-$11] = $75,000
Cost of marginal investment in A/R:

Turnover with A/R with proposed plan: 360/30 = 12

Average investment with proposed plan= [275,000 units X $11/$12] = $252,083

Turnover of A/R with present plan = 360/36 = 10

Average investment with present plan = [300,000 units X $11/$10]= $330,000

Reduced investment in A/R= $77,917

Reduction in cost of marginal investment in A/R= $77,917 X 0.15 = $11,688.
Reduction in marginal bad debts:

Bad debts with present plan = (0.012) X $42,00,000 = $50,400

Bad debts with proposed plan = 0.008 X 275,000 X $14= $30,800

Reduction in bad debts= $50,400 - $30,800 = $19,600

A firm is evaluating an accounts receivable change that would increase bad debts from 2% to 4% of sales. Sales are currently 50,000 units, the selling price is $20 per unit, and the variable cost per unit is $15. As a result of the proposed change, sales are forecast to increase to 60,000 units.

1. 
   What are bad debts in dollars currently and under the proposed change?
   
2. 
   Calculate the cost of the marginal bad debts to the firm.
   
3. 
   Ignoring the additional profit contribution from increased sales, if the proposed change saves $3,500 and causes no change in the average investment in accounts receivable, would you recommend it? Explain.
   
4. 
   Considering all changes in costs and benefits, would you recommend the proposed change? Explain.
   

Answer:

1. 
   Proposed Plan (60,000 units X $20 X 0.04) = $48,000
   

2. 
   Cost of marginal debt = [$48,000 - $20,000] = $28,000
   
3. 
   No because the cost of marginal debt exceeds the savings of $3,500.
   
4. 
   Additional profit contribution from sales:
   

Cost of marginal debt from (ii) (28,000)

Savings 3,500

Net benefit from implementing new plan $25,500