Modern Kitchenware Co. specializes in the manufacturing and distribution of items used in the kitchen. Among its many products are microwave ovens, toasters, electric can openers, etc. Its home base is in Kansas City and the firm sells to retailers throughout the U.S. and Canada. Its customers range from small retail outlets in strip shopping centers to major customers such as Sears and J. C. Penney. In the most recent fiscal year, its sales were $18 million with $2,500,000 in aftertax profits.

The firm’s CEO is Beth Graham, who holds a B.A. in economics from St. Louis University. Beth has moved up through the ranks as both a product manager and VP of marketing.

She has implemented an inventory control system that was thought by many to be the finest in the kitchen supply industry. The computer-based system kept hourly tabs on inventory in stock at Kansas City as well as the ten distribution centers throughout the country.

Management of Accounts Receivable

Beth felt a good deal less confident about the firm’s ability to control and manage the level of accounts receivable. Historically, the firm shipped out its goods with a 30-day pay period allowed, with no cash discount offered. An analysis of current accounts receivable indicated the pattern of receivables shown in Table 1.

In looking over the numbers, Beth felt the customers, on average, were taking over 30 days to pay. The receivables were based on average daily credit sales of $54,274 throughout the year.

Beth called in Al Becker, the chief financial officer, and asked him what he thought the problem was. He said that because no cash discount was being offered for early payment, customers were sometimes lax in their payment pattern.

A Potential Cash Discount

Beth told Al to consider the impact of a cash discount on the accounts receivable balance of the firm as well as its profitability.

Following Beth’s instructions, Al evaluated the effect of the three alternative cash discount policies shown in Table 2.

He ran some pilot studies among customers and determined the results below.

Ten percent of the customers would take advantage of the 1 percent discount by paying within 10 days. If the two percent discount were offered, 25 percent would take it, and if the 3 percent discount were offered, 60 percent of the customers would take advantage of it. In each case, it was assumed that those who do not take the discount would pay at the end of 30 days.

Table 1. Accounts Receivables Outstanding, December 2015

	Days Outstanding		Amount
	0 – 10 days		20,000
	10 – 20 days		150,000
	20 – 30 days		400,000
	30 – 40 days		650,000
	40 – 50 days		430,000
	50 – 60 days		350,000
		Total A/R	2,000,000

Table 2. New Terms for Cash Discounts

	Alternative	Terms
	1	1/10, net 30
	2	2/10, net 30
	3	3/10, net 30

He then computed the new average collection period(s) based on the data in the prior paragraph. With an assumption of average daily credit sales remaining at $54,274 per day, he also computed the anticipated new accounts receivable balance based on the three different cash discount policies.

He was informed by his corporate treasurer that any freed-up funds from accounts receivable could be used elsewhere in the corporation to earn a return of 18 percent.

All this information was reported back to Beth, and she suggested that a thorough analysis be conducted of all the implications of the cash discount policies.

Questions

1. Compute the current average collection period based on the data in Table 1. In doing this, multiply the midpoint of the days outstanding, by the weight assigned to that category. For example, the midpoint of the second company is 15 days and the category represents 7.5 percent of total accounts receivable ($150,000/$2,000,000). Its value is 1.125 days (15 days × .075). After this process is followed for all six categories, add up the total to get the average collection period.
2. Compute the new average collection period based on the terms in Table 2 and the results of the pilot study. Use the simplifying assumption that under the new policies all customers will all pay at the end of the 10th day or the end of the 30th day.
i.e., for the 1/10, net 30
10% × 10 days = 1 day
90% × 30 days = 27 days
28 days average collection period
3. Assuming average daily credit sales remain at $54,274 per day, what will be the new accounts receivable balance based on the three new cash discount policies?
Accounts receivable = average collection period × average daily credit sales
4. Compute the cost of the cash discount based on the three policies under consideration. Recall that total credit sales were $18 million.
Multiply total credit sales times the percent that use the discount for each new discount policy times the size of the discount.
5. Compute the amount of freed up funds based on the three different cash discount policies based on the following:
Old accounts receivable (given in table 1)
New accounts receivable (Question 3)
Freed up funds
6. Assuming an 18 percent return can be earned on the freed up funds, what is the return that can be earned under the three cash discount policies?
7. Subtract the cost of the cash discount (Question 4) from the return on the freed up funds (Question 6) to determine the actual profitability or loss under the three cash discount policies.
Which of the three policies is the most profitable?
8. After looking at all the data, Beth decides to only consider Alternatives 1 and 2. She decides that the 2/10, net 30 cash discount could increase credit sales by $1 million. The 1/10, net 30 is assumed to have no impact on sales. Assume a 9 percent before tax profit margin on the new sales. Also assume the 2 percent cash discount must be subtracted. Further, assume the new sales will require a new investment in accounts receivable of $27,750. These funds could earn 20% if invested elsewhere. (The 20% is return on investment, whereas the 9% referred to above is return on sales.)

Under the new set of facts, is the 2/10, net 30 policy now superior to the 1/10, net 30 policy?

Take the profitability computed for the 2/10, net 30 policy in Question 7, and add to that the increased profitability (9% return minus costs) detailed above. Compare your new total answers for the profitability of the 2/10, net 30 policy to the answer for the 1/10, net 30 policy in Question 7.

Which policy should the firm choose?

Answer rating: 100% (QA)

Question 1 Current average collection period 01 10 015 15 02 20 025 25 0225 225 0175 175 06 34 days ... View the full answer