Question 10.S-TQ.1: Kaya Ltd is a manufacturing business with sales revenue of £...
Kaya Ltd is a manufacturing business with sales revenue of £30 million per year. All sales are on credit and no significant change in annual sales revenue is expected for the fore-seeable future. The directors of Kaya Ltd are concerned that customers are taking too long to pay, which is placing a strain on the liquidity of the business. The average trade receiv-ables collection period is 60days and the business has a bank overdraft of £8 million, on which it pays annual interest of 10 per cent. The directors estimate that the credit control department costs £250,000 per year to operate.
To deal with the problem, two proposals are currently being considered. The first is to use a factor to undertake the credit control function. It is expected that a factor would reduce the average collection period for trade receivable to 30 days, which is in line with the terms of trade. In addition, the factor will advance 80 per cent of the trade receivables for an annual interest charge of 8 per cent per year. A further 3 per cent of annual sales revenue will be charged by the factor for its services. The effect of using the factor will be to reduce the cost of the credit control department to a notional figure of £20,000.
The second proposal is to offer a discount of 2^{1}/{}_{2} per cent to customers for prompt payment. The discount will be given to all customers who pay within 20 days and it is expected that 40 per cent of customers will avail themselves of the discount by paying on the last day of the discount period. The remaining 60 per cent of customers will continue to pay, on average, after 60 days. This proposal is expected to reduce credit control costs by 12 per cent.
Required:
Evaluate each of the proposals under consideration and recommend which, if either, should be adopted.
(Hint: The total cost of each option, as well as the total cost of the existing arrangements, should be compared. Refer to Chapter 6 if you need to brush up on your knowledge of factoring.)
Workings should be to the nearest £000.
Kaya Ltd
| Cost of current arrangements | |
| £000 | |
| Interest cost of average receivables outstanding ((£30m × 60/365) × 10%] | 493 |
| Cost of credit control department | \underline{250} |
| Total cost | \underline{743} |
| Factoring arrangement | |
| £000 | |
| Factoring fee (£30m × 3%) | 900 |
| Interest on factor loan (assuming 80% advance and reduction in average credit period) ((£24m × 30/365) × 8%) |
158 |
| nterest on overdraft (remaining 20 per cent of receivables financed in this way) ((£6m × 30/365) × 10%) |
49 |
| Cost of credit control department | \underline{20} |
| Total cost | \underline{1,127} |
| Cost of discounts | |
| £000 | |
| Cost of discounts (2^{1}/{}_{2}% × (40% × £30m)) | 300 |
| Cost of credit control department (£250,000 × 0.88) | 220 |
| Interest on overdraft ((20/365 × 40% × £30m) × 10%) + ((60/365 × 60% × £30m) × 10%) | \underline{362} |
| Total cost | \underline{882} |
The calculations reveal that the cost of offering a discount is much cheaper than the factoring option. However, neither option is cheaper than the current arrangements. The directors, therefore, need to think again about the best way to deal with the problem.