Adopting a rigorous receivables collection system is essential to the ability of a company to pay its suppliers and employees, and even survive. Even where such a system is adopted and effective steps are taken to chase late payers, a company may still want to speed up the collection of cash from its customers.
This article considers two methods a company could adopt in order to speed up the collection of cash from its customers. Additionally, worked examples show how these methods can be evaluated in order to decide whether or not they should be adopted given the circumstances particular to a specific company. This has been a common exam requirement over the years and, as there is no set approach or formula, students very often lack the confidence to attempt such questions.
Early settlement discount
An early settlement discount involves a company offering a small percentage discount to customers who pay within a defined short period. For instance a 1% discount may be offered to those who pay within 10 days.
The key advantage of offering such discounts is that customers take the discount and pay earlier than usual, so the company receives the cash sooner. It has also been argued that by effectively offering a choice of payment terms, the company is likely to satisfy more customers, and that by encouraging early payment, the risk of bad debts is reduced.
However, such discounts suffer from a number of key problems. First, it is difficult to decide on suitable discount terms. If the discount is made attractive to customers it is likely to be too costly to the company, whereas if the discount is not too costly to the company it is unlikely to be attractive to many customers. Second, the introduction of such a discount will make the management of the sales ledger more complex and costly to run and is likely to make the budgeting of receipts from customers more difficult, as the company could not be sure whether the discount will or will not be taken. The final – and in reality very often the biggest – problem is that all too often customers will abuse the discount by taking it despite not paying early. When this occurs, the company is left to decide between spending time and effort recovering what is often a small amount, or writing the discount off and encouraging such behaviour. Obviously, neither of these options is attractive.
Example 1
Melvin Co has a turnover of $900,000 (90% of which is on credit) and receivable days are currently 42 despite the company only offering 30-days’ credit. Melvin Co finances its receivables using its overdraft which has an annual interest cost of 8% and has a contribution margin of 30%.
Melvin Co is considering the introduction of an early settlement discount at the same time as extending their standard credit terms to 50 days. The company would offer customers a 1% discount for payment within 14 days. It is anticipated that 40% of customers will take the discount, while those that do not take the discount will keep to the new standard credit terms. As a result of the extended credit terms, credit sales are expected to rise by 10%. Due to the extra administration involved it is thought that administration costs will rise by $10,000 per year.
Required
Evaluate whether or not Melvin Co should offer the discount.
Suggested approach
In some questions of this nature it may be worth doing some preliminary calculations. In this case, the calculation of credit sales and the anticipated increase in sales would be worth evaluating:
Existing credit sales: $900,000 × 90% = $810,000
Expected increase in credit sales: $810,000 × 10% = $81,000
Revised credit sales: $810,000 + $81,000 = $891,000
Having carried out any preliminary calculations, an annual cost and benefit table should be constructed and each cost or benefit should be evaluated and put into the table.
The important annual benefit, and always the one that is hardest to calculate, is the annual finance saving on reduced receivables as the overdraft will have been reduced and hence an interest saving will arise. I suggest that you leave this calculation to last as it is best to calculate the other costs and benefits first to obtain the easy marks.
The second benefit to Melvin Co will be the contribution earned on the extra sales. This can be easily evaluated by multiplying the expected increase in credit sales by the contribution margin:
$81,000 × 30% = $24,300
The costs to be evaluated are the additional administration cost which is given as $10,000 per year, and the cost of the discount itself. The discount cost is a function of the total credit sales, the proportion of customers expected to take the discount and the percentage discount offered:
$891,000 × 40% × 1% = $3,564
The calculations carried out so far are relatively straightforward and can be shown on the face of the cost and benefit table. Hence, prior to calculating the annual interest saving on the reduced receivables, the cost and benefit table should be as follows: