Davis Manufacturing Industries (DMI) produces and sells 20,000 units of a machine tool each year. All sales are on credit, and DMI charges all customers $500 per unit. Variable costs are $350 per unit, and the firm incurs $2 million in fixed costs each year.
DMI’s top managers are evaluating a proposal from the firm’s CFO that the firm relax its credit standards to increase its sales and profits. The CFO believes this change will increase unit sales by 4%. Currently, DMI’s average collection period is 40 days, and the CFO expects this to increase to 60 days under the new policy. Bad debt expense is also expected to increase from 1 to 2.5% of annual sales. The firm’s board of directors has set a required return of 15% on investments with this level of risk. Assume a 365-day year.
a. What is DMI’s contribution margin? By how much will profits from increased sales change if DMI adopts the new credit standards?
b. Under the current credit standards, what is DMI’s average investment in accounts receivable? What would it be under the proposed credit standards? What is the cost of this additional investment?
c. What is DMI’s cost of marginal bad debts resulting from the relaxation of its credit standards?
d. What is DMI’s net profit (or loss) from adopting the new credit standards? Should DMI relax its credit standards?