Question

The Pettit Corporation has annual credit sales of $2 million. Current expenses for the collection department are $30,000, bad debt losses are 2 percent, and the DSO is 30 days. Pettit is considering easing its collection efforts so that collection expenses will be reduced to $22,000 per year. The change is expected to increase bad debt losses to 3 percent and to increase the DSO to 45 days. In addition, sales are expected to increase to $2.2 million per year. Should Pettit relax collection efforts if the opportunity cost of funds is 12 percent, the variable cost ratio is 75 percent, and its marginal tax rate is 40 percent? Assume 365 days per year.

. Use the income statement approach to find the incremental bad debt losses

. Use the income statement approach to find the incremental cost of carrying receivables

. Use the income statement approach to find the incremental pre-tax profits from this proposal

. Use the incremental analysis approach to find the incremental bad debt losses

. Use the incremental analysis approach to find the incremental cost of carrying receivables

. Use the incremental analysis approach to find the incremental pre-tax profits from this proposal

Answer 1

Present (A)			Proposed (B)		Incremental (A)-(B)
	current sales	2000000		New sales	2200000	200000
	credit period	30 days		credit period	45 days
	Receivables	164384	(sales*30/365)	Receivables(sales*45/365)	271233	106849
	bad debt-2%	40000		bad debt-3%	66000	26000
	carrying cost of receivables-12%*164384	19726		carrying cost of receivables=12%*271233	32548	12822
	Contribution	500000		Contribution	550000	50000
	Variable cost	75%
	carrying cost	12%
	Tax rate	40%
	Increase in Sales	200000
	Increase in contribution	50000	(contribution=100-75=25)*inc in sales)
	Solution:
a	Incremental bad debts
	26000 (as per above working)
b	Incremental cost of carrying debts
	12822 (as per above working)
c	Incremental Pretax profits:
	Increase in Contribution	50000	(as per working note)
	(increase in profits)
	Incremental contribution is equal to pretax profits)
	Note:
	In both Income statement approach (means estimating the amount based on ratios/judgements without referring to actual balance in accounts)
	and incremental analysis approach, the solution would be same while calculating the incremental bad debts, pretax profits etc., because in both,
	incremental figures are considered