Question 16.5: Worrall plc’s sales revenue for 2009 was £8m. Costs of sales...
Worrall plc’s sales revenue for 2009 was £8m. Costs of sales were 80% of sales revenue. Bad debts were 2% of sales. Cost of sales variable costs were 90% and fixed costs were 10%. Worrall’s cost of finance is 10% per annum. Worrall plc allows its customers 60 days’ credit, but is now considering increasing this to 90 days’ credit because it believes that this will increase sales. Worrall plc’s sales manager estimated that if customers were granted 90 days’ credit, sales may be increased by 20%, but that bad debts would increase from 2% to 3%. The finance director calculated that such a change in policy would not increase fixed costs, and neither would it result in changes to trade payables and inventories.
Would you recommend that Worrall plc increase customer credit to 90 days?
| Cost of sales is 80% of sales | ||
| Variable cost of sales | 80% × 90% | = 72% of sales |
| Therefore | ||
| Contribution | = 28% of sales | |
| Proposed trade receivables | ||
| Sales revenue, increased by 20% is | 120% × £8m = £9.6m | |
| Credit allowed increased to 90 days | £9.6m × 90/365 | = £2,367,123 |
| Current trade receivables | £8m × 60/365 | = \underline{£1,315,068} |
| Increase in trade receivables | = \underline{£1,052,055} | |
| Gains | ||
| Increase in contribution | (£9.6m − £8.0m) × 28% | = \underline{£448,000} |
| Losses | ||
| Increase in bad debts | (3% × £2,367,123) − (2% × £1,315,068) | = £44,713 |
| Increase in financing costs | £1,052,055 × 10% | = \underline{ £105,206} |
| Total losses | \underline{£149,919} | |
| Net gain per annum | \underline{£298,081} |
The net gain to Worrall Ltd is £298,081 per annum and so an increase to 90 days’ credit may be recommended.