Hi! I dont get the first and second question. I don't know if I have to use 50% of the gross sales to calculate the DSO ?

Hope you can help me

CASE 34 Kiddyland Clothes, Inc. Credit Policy Kiddyland Clothes manufactures children's clothing, including such accessories as socks and belts. The company has been in business since 1952, mainly supplying prvate label merchandise to large department stores. In 1987, however, the company started producing its own line of children's clothing under the brandname "Yuppiewear." An increasing number of two-income families has been accompanied by an increasing demand for high-status children's clothing, and Kiddyland was the first in its field to recognize this trend. When Kiddyland's sales were primarily for private labels, the firm's financial manager did not have to worry much about its overall credit policy. Most of its sales were negotiated directly with the department stores' buyers, and the resulting contracts contained specific credit terms. The new line, however, represented a significant change-it is sold through numerous wholesalers under standard credit terms, so credit policy per se has become important. Lisa Wright, the assistant treasurer, has been assigned the task of reviewing the company's current credit policy and recommending any desirable changes. Kiddyland's current credit terms are 2/10, net 30. Thus, wholesalers buying from Kiddyland receive a 2 percent discount off the gross purchase price if they pay within 10 days, while customers who do not take the discount must par the full amount within 30 days. The company does check the financial strength of potential customers, but its standards for granting credit are not high. Similarly, it does have procedures for collecting past due accounts, but its collections policy could best be descrbed as passive. Gross sales to wholesalers average about $10 million ayear, and 50 percent of the paying wholesalers (by dollar volume) take the discount and pay, on average, on Day 10. Another 30 percent of the payers generally pay the full amount on Day 30, while 20 percent tend to stretch Kiddyland's terms and do not actualIy pay, on average, until Dar 40. Two percent of Kiddyland's gross sales to wholesalers end up as bad debt losses. Don McCarthy, the treasurer, and Wrighi's boss, is convinced that the firm should tighten its credit policy. According to McCarthy, good customers will pay on time regardless of the terms, and the ones who would complain about a tighter polcy are probably not good customers. Wright must make an analysis and then recommend a course of action. For political reasons, she has decided to focus on a tighter policy, under which a 4 percent discount would be offered to customers who pay cash on delvery (COO) and 20 days of credit would be offered to customers who elect not to take the discount. Also, under the new policy stricter credit standards would be applied, and a tougher colIection policy would be enforced. This policy has been dubbed 4/COD, net 20. McCarthy likes this policy-he believes that increasing the discount would both bring in new customers and encourage more of Kiddyland's existing customers to take the discount. As a result, he believes that sales to wholesalers would increase from $10 million to $11 million annualIy, that 60 percent of the paying customers would take the discount, that 30 percent of the payers would pay on Day 20, that 10 percent would pay late on Day 30, and that bad debt losses would be reduced to 1 percent of gross sales. McCarthy's is not the only position, though-Emie Bush, the sales manager, has argued for an easier credit policy. Bush thinks that the proposed change would resuIt in a drastic loss of sales and profits. Kiddyland's variable cost-to-sales ratio is 75 percent; its pre-tax cost of carrying receivables is 12 percent; and the company can expand without any problems (or any cost increases) because it can subcontract production that it cannot handle in-house. Further, McCarthy is convinced that neither the variable cost ratio nor the cost of capital would change as a result of a credit polcy change. Ernie Bush, however, thinks that the variable cost ratio might increase significantIy if sales rise so much that the company is forced to use outside supplers. Also, Bush, based on discussions with the cost accounting staff, thinks that the variable cost ratio might rise as high as 90 percent this coming year, even without an increase in sales, due to higher labor costs under a contract now being negotiated. Everyone agrees that there is lttle chance that costs will decline, regardless of the credit policy decision. Kiddyland's federal-plus-state tax Tale is 40 percent. Now Wright must conduct an analysis to estimate the effect of the proposed credit policy change on Kiddyland's profitability. She and McCarthy are very concemed about the analysis, both because of its imporlance to the company and also because of its "poltical implications" -the sales and production people have been lobbying against any credit tightening because they do not want to take a chance on losing sales and having to cut production, and also because they question the assumptions McCarthy wants to use. Therefore, Wright knows that her report will be critically reviewed. Working with McCarthy, she prepared the following set of questions for use as a guide in drafting her report Put yourself in her position and then answer the following questions. As you answer each question, think about the follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed. Questions 1. What is Kiddyland' s current days sales outstanding (DSO) (also called average collection period [ACP])? What would be the expected DSO if the credit policy change were made? 2. What is the dollar amount of bad debt losses under the current policy? What would be the expected bad debt losses under the proposed policy? 3. What is the cost of granting discounts under the current policy? What would be the expected cost under the new policy? 4. What is Kiddyland's dallar cost of carrying receivables under the current policy? What would be the expected cost under the new policy? (Use a 360-day year.) 5. What is the expected incremental profit associated with the proposed change in credit terms? Should Kiddyiand make the change? (Hint: Construct income statements under each policy, and focus on the expected change. See Table 1 for a guide.) Table 1 Incremental Profit Analysis Proposed Policy Current Policy Difference Gross sales X 10,000,000. X Discounts taken X 98,000. X Net sales X 9,902,000. X Production costs X 7,500,000. X Net earnings before credit costs X 2,402,000. X Receivables carrying cost X 55,000. X Bad debt losses X 200,000. X Net earnings before taxes X 2,147,000. X Taxes (40%) X 858,800. X After-tax profit X 1,288,200. X Credit-related costs: The following question presents an algebraic approach to analyzing changes in credit policy. Answer it only if it is assigned by your instructor. 6. As an alternative to constructing profit statements, an algebraic approach has been developed that focuses directly on the change in profits. To use this approach, it is first necessary to define the following symbols: S0 SN = current gross sales. = new gross sales after the change in credit policy. Note that SN can be greater than or less than S0. V = variable costs as a percentage of gross sales. V includes production costs, inventory carrying costs, the cost of administering the credit department, and all other variable costs except bad debt losses, receivables carrying costs, and the cost of giving discounts. 1 - V = contribution margin, or the proportion of gross sales that goes toward covering fixed costs and increasing profits. K = cost of financing the firm' s receivables. DSO0 = current days sales outstanding DSON = new average days sales outstanding after change in credit policy. B0 = current bad debt losses as a proportion of current gross sales. BN = new bad debt losses as a proportion of new gross sales. P0 = proportion of current-collected gross sales that are discount sales. PN = proportion of new-collected gross sales that are discount sales. D0 = current discount offered. DN = discount offered under new policy. T = tax rate Calculate values for the incremental change in the firm's investment in receivables, M, and the incremental change in after-tax profits, _P, as follows: M = V[(DSON - DSO0)(S0 / 360)] + V[(DSO0)(SN - S0) /360] P = (1 - T) {(SN - S0)(1 - V) - kI - (BNSN - B0S0) - [(DNSNPN (1 - BN) - D0S0P0 (1 - Bo))] } Note that, in the profit equation, the first term, (1 - T)(5N - 50)(1 - V), is the incremental after-tax gross profit, the second term, kI, is the incremental cost of carrying receivables, the third term, BNSN - B0S0, is the incremental bad debt losses, and the last term, DNSNPN (1 - BN) - D0S0P0 (1 - Bo), is the incremental cost of discounts.1 Use the equations presented here to estimate the change in profits associated with the new policy. 1 Note that the analysis presented here is somewhat simplified in that the opportunity cost of the incremental investment in receivables from current customers is not considered. For a complete discussion of the analysis, see Eugene F. Brigham and Louis C. Gapenski, Intermediate Financia! Management, 3rd ed., Chapter 19