Tricia Haltiwinger, the president of Braam Industries, has been exploring ways of improving the company’s financial performance. Braam Industries manufactures and sells office equipment to retailers. The company’s growth has been relatively slow in recent years, but with an expansion in the economy, it appears that sales may increase more quickly in the future. Tricia has asked Andrew Preston, the company’s treasurer, to examine Braam’s credit policy to see if a different credit policy 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 Braam’s screening and collection process, the default rate on credit is currently only 2.1 percent. Andrew has examined the company’s credit policy in relation to other vendors, and has determined that three options are available.

The first option is to relax the company’s 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 firm’s receivables would increase, and the receivables period would increase. The credit policy change would impact all four of these variables in different degrees. Andrew has prepared the following table outlining the effect on each of these variables:

Braam's variable costs of production are 45 percent of sales, and the relevant interest rate is a 6 percent effective annual rate. Which credit policy should the company use? Also, notice that in option 2 the default rate and administrative costs are below those in option 3. Is this plausible? Why or why not?

Transcribed Image Text:

Annual Sales (millions) Default Administrative Rate of sales) 1 .90% 2.60 2.20 2.50 Costs (% ofsales) 1.60% 2.40 1.90 2.10 Receivables Period 38 days 41 Current policy Option I Option 2 Option 3 $116 130 129 132 49