CREDIT POLICY AT HOWLETT INDUSTRIES

Sterling Wyatt, the president of Howlett Industries, has been exploring ways of improving the companys financial performance. Howlett manufactures and sells office equipment to retailers. The companys growth has been relatively slow in recent years, but with an expansion in the economy, it appears that sales may increase more rapidly in the future. Sterling has asked Evan Bradds, the companys treasurer, to examine Howletts credit policy to see if a change can help increase profitability.

The company currently has a policy of net 30. As with any credit sales, default rates are always of concern. Because of Howletts screening and collection process, the default rate on credit is currently only 1.6 percent. Evan has examined the companys credit policy in relation to other vendors, and he has found three available options.

The first option is to relax the companys decision on when to grant credit. The second option is to increase the credit period to net 45, and the third option is a combination of the relaxed credit policy and the extension of the credit period to net 45. On the positive side, each of the three policies under consideration would increase sales. The three policies have the drawbacks that default rates would increase, the administrative costs of managing the firms receivables would increase, and the receivables period would increase. The effect of the credit policy change would impact all four of these variables to different degrees. Evan has prepared the following table outlining the effect on each of these variables:

Annual Sales (millions) Default Rate (% of sales) Administrative Costs (% of sales) Receivables Period Current Policy Option 1 Option 2 Option 3 $134 158 155 170 1.6% 2.5 1.8 2.2 2.2% 3.2 2.4 3.0 37 days 40 days 50 days 48 days

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Howletts variable costs of production are 45 percent of sales, and the relevant interest rate is a 6 percent effective annual rate.

QUESTIONS

1. Which credit policy should the company use?

2. Notice that in Option 3, the default rate and the administrative costs both exceed those in Option 2. Is this plausible? Why or why not?