Mayo Computers Ltd. has annual sales of $20 million before taking into account bad debts of $0.1 million. All sales made by the business are on credit and, at present, credit terms are negotiable by the customer. On average, the collection period for accounts receivable is 60 days. Receivables are financed by an overdraft bearing a 14% rate of interest per year. The business is currently reviewing its credit policies to see whether more efficient and profitable methods could be employed. Only one proposal has so far been put forward concerning the management of receivables.
The credit control department has proposed that customers should be given a 2.5% discount if they pay within 30 days. For those who do not pay within this period, a maximum of 50 days' credit should be given. The credit department believes that 60% of customers will take advantage of the discount by paying at the end of the discount period, and the remainder will pay at the end of 50 days. The credit department believes that bad debts can be effectively eliminated by adopting the above policies and by employing stricter credit investigation procedures, which will cost an additional $20,000 a year. The credit department is confident that these new policies will not result in any reduction in sales revenue.
Required:
Calculate the net annual cost (or savings) to the business of abandoning its existing credit policies and adopting the proposal of the credit control department.