HOT AIR Company of Atlanta sells fans and heaters to retail outlets throughout the Southeast. Joe Smith, the president of the company, is thinking about changing the firm’s credit policy to attract customers away from competitors. The present policy calls for a 1/10, net 30 cash discount. The new policy would call for a 3/10, net 50 cash discount. Currently, 30 percent of Hot Air customers are taking the discount, and it is anticipated that this number would go up to 50 percent with the new discount policy. It is further anticipated that annual sales would increase from a level of $400,000 to $600,000 as a result of the change in the cash discount policy. The increased sales would also affect the inventory level. The average inventory carried by Hot Air is based on a determination of an EOQ. Assume sales of fans and heaters increase from 15,000 to 22,500 units. The ordering cost for each order is $200 and the carrying cost per unit is $1.50 (these values will not change with the discount). The average inventory is based on EOQ/2. Each unit in inventory has an average cost of $12. Cost of goods sold is equal to 65 percent of net sales; general and administrative expenses are 15 percent of net sales, and interest payments of 14 percent will only be necessary for the increase in the accounts receivable and inventory balances. Taxes will be 40 percent of before-tax income.
a. Compute the accounts receivable balance before and after the change in the cash discount policy. Use the net sales (total sales minus cash discounts) to determine the average daily sales.
b. Determine EOQ before and after the change in the cash discount policy. Translate this into average inventory (in units and dollars) before and after the change in the cash discount policy.
c. Complete the following income statement. Before Policy Change After Policy Change Net sales (Sales – Cash discounts)
................ Cost of goods sold........................................
Gross profit...................................................
General and administrative expense.............
Operating profit............................................
Interest on increase in accounts receivable and inventory (14%).................
Income before taxes......................................
Taxes.............................................................
Income after taxes........................................
d. Should the new cash discount policy be utilized? Briefly comment.