Question
Alpha Ltd. is examining the question of relaxing its credit policy. It sells at present 20,000 units at a price of Rs. 100 per unit. The variable cost per unit is Rs. 88 and average cost per unit at the current sales volume is Rs. 92. All the sales are on credit, the average collection period being 36 days.
Answer :
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To analyze the implications of relaxing the credit policy for Alpha Ltd., it is essential to evaluate the effects on sales, costs, receivables, and overall working capital management. Currently, Alpha Ltd. sells 20,000 units at Rs. 100 per unit, with a variable cost of Rs. 88 per unit and an average cost of Rs. 92 per unit. The gross contribution per unit, calculated as selling price minus variable cost, is Rs. 100 – Rs. 88 = Rs. 12 per unit. At the current sales volume, total contribution amounts to 20,000 × 12 = Rs. 240,000. The net profit per unit, considering the average cost, is Rs. 100 – Rs. 92 = Rs. 8, giving total profit of 20,000 × 8 = Rs. 160,000. The current credit policy results in an average collection period of 36 days. This indicates that accounts receivable are tied up for over a month, affecting the liquidity position and the firm’s ability to finance operations without resorting to external borrowing. Managing receivables is a crucial component of working capital management, as it directly impacts cash flow. Extending the credit period may attract more customers, potentially increasing sales volume. However, it will also increase the investment in accounts receivable, raising the risk of bad debts and affecting the cash conversion cycle. To evaluate the impact of relaxing the credit policy, one must consider several factors. First is the expected increase in sales volume. If the company relaxes its credit terms, it is likely to offer longer payment periods, making the product more attractive to customers. Suppose the relaxation leads to a 10% increase in sales, the new sales volume will be 22,000 units. The total contribution at the current variable cost remains Rs. 12 per unit, resulting in a contribution of 22,000 × 12 = Rs. 264,000. The total profit, assuming average cost remains unchanged, would be 22,000 × 8 = Rs. 176,000. Second, the increase in accounts receivable needs careful calculation. Under the current policy, average daily sales are 20,000 × 100 / 365 ≈ Rs. 5,479 per day. With an average collection period of 36 days, accounts receivable currently stand at 36 × 5,479
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