Bailey Distributing Company sells small appliances to hardware stores throughout the west. Chuck

Bailey, the president of the company, is thinking about changing the credit policies offered by the

firm to attract customers away from competitors. The current policy calls for a $1/10,$ net $30,$ and the

new policy would call for a $3/10,$ net $50.$ Currently, $40$ percent of Bailey customers are taking the

discount, and it is anticipated that the number would go up to $50$ percent with the new discount policy.

It is further anticipated that annual sales would increase from a level of $$200,000$ to $$250,000$ as a result

of the change in the cash discount policy.

The increased sales would also affect the inventory level carried by Bailey. The average inventory carried by

Bailey is based on a determination of an EOQ. Assume unit sales of fans and heaters will increase from

$20,000$ to $25,000$ units. The ordering cost for each order is $$100$ and the carrying cost per unit is $$1\mathrm{.}00$

$($these values will not change with the discount$).$ Each unit in inventory has an average cost of $$6\mathrm{.}50.$

Cost of goods sold is equal to $65$ percent of net sales, general and administrative expenses are

equal to $10$ percent of net sales, and interest payments of $12$ percent will be necessary only

for the increase in the accounts receivable and inventory balances. Taxes will equal $25$ percent

of before$-$tax income.

a$.$ Compute the accounts receivable balance before and after the change in the cash discount policy.

Use the net sales $($Total sales $-$ Cash discounts$)$ to determine the average daily sales and the

accounts receivable balances.

b$.$ Determine EOQ before and after the change in cash discount policy. Translate this into average

inventory $($in units and dollars$)$ before and after the change in the cash discount policy.

c$.$ Complete the income statement before and after the policy change.

d$.$ Should the new cash discount policy be utilized? Briefly comment.

Solution

Problem $7-47($LO$4,$ LO$5)$

Instructions

Use the key facts below and information from the problem to complete the templates below.

Key Facts: Before After

Sales level $$2,00,000$ $$2,50,000$

Anticipated sales level $20,00025,000$

Discount $1\%3\%$

$\%$ taking discount $40\%50\%$

Ordering cost per order $$100\mathrm{.}00$

Carrying cost per unit $$1\mathrm{.}00$

Average cost per unit $$6\mathrm{.}50$

a$.$ Compute the accounts receivable balance before and after the change in the cash discount policy.

Use the net sales $($Total sales $-$ Cash discounts$)$ to determine the average daily sales and the

accounts receivable balances.

Before Policy Change

Average collection period $22$ days

Average daily sales $$545\mathrm{.}75$

Accounts receivable $$12,007$

After Policy Change

Average collection period $30$ days

Average daily sales $$674\mathrm{.}66$

Accounts receivable $$20,240$

b$.$ Determine EOQ before and after the change in cash discount policy. Translate this into average

inventory $($in units and dollars$)$ before and after the change in the cash discount policy.

Before After

EOQ $2,0002,236$ appliances

Average inventory $1,0001,118$ units

Average inventory $($$$)$ $$6,500$ $$7,267$

c$.$ Complete the income statement before and after the policy change.

Before After

Net sales $$1,99,200$ $$2,46,250$

Cost of goods sold $1,29,4801,60,063$

Gross profit $69,72086,188$

General and administrative $19,92024,625$

Operating profit $49,80061,563$

Opportunity cost of $1,080$

A$/$R and inventory investment

Income before taxes $49,80060,482$

Taxes $12,45015,121$

Income after taxes $$37,350$ $$45,362$

d$.$ Should the new cash discount policy be utilized?

Utilize new cash discount policy. Interest cost on the increased accounts receivable and

and inventory is small in comparison to the increased operating profit from the policy change.

There would be a slight increase in ordering costs to $11\mathrm{.}18$ orders $(25,000/2,236)$ from

$10$ orders per year $(20,000/2,000).$ This will cost an additional $$100(1$ $$100).$ To the

extent that carrying costs do not include the opportunity cost of funds tied up in

inventory, carrying costs will increase up to $$118($$$1$ $$118).$