Question

Upscale Toddlers, Inc., manufactures children’s clothing,including such accessories as socks and belts. The company has beenin business since 1955, mainly supplying private label merchandiseto large department stores. In 1990, however, the company startedproducing its own line of children’s clothing under the brandname“Yuppiewear.” An increasing number of two-income families has beenaccompanied by an increasing demand for high-status children’sclothing, and Toddlers was the first in its field to recognize thistrend.
When Toddlers’ sales were primarily for private labels, the firm’sfinancial manager did not have to worry much about its overallcredit policy. Most of its sales were negotiated directly withdepartment store buyers, and the resulting contracts containedspecific credit terms. The new line, however, represents asignificant change. It is sold through numerous wholesalers understandard credit terms, so credit policy per se has becomeimportant. Elizabeth Hardin, the assistant treasurer, has beenassigned the task of reviewing the company’s current credit policyand recommending any desirable changes.
Toddlers’ current credit terms are 2/10, net 30. Thus, wholesalersbuying from Toddlers receive a 2 percent discount off the grosspurchase price if they pay within ten days, while customers who donot take the discount must pay the full amount within thirty days.The company does check the financial strength of potentialcustomers, but its standards for granting credit are not high.Similarly, it does have procedures for collecting past-dueaccounts, but its collections policy could best be described aspassive. Gross sales to wholesalers average about $15 million ayear, and 50 percent of the paying wholesalers take the discountand pay, on average, on Day 10. Another 30 percent of the payersgenerally pay the full amount on Day 30, while 20 percent tend tostretch Toddlers’ terms and do not actually pay, on average, untilDay 40. Two percent of Toddlers’ gross sales to wholesalers end upas bad debt losses.
Nathan Langly, the treasurer and Hardin’s boss, is convinced thatthe firm should tighten up its credit policy. According to Langly,good customers will pay on time regardless of the terms, and theones who would complain about a tighter policy are probably notgood customers. Hardin must make an analysis and then recommend acourse of action. For political reasons, she has decided to focuson a tighter policy, under which a 4 percent discount would beoffered to customers who pay cash on delivery (COD) and twenty daysof credit would be offered to customers who elect not to take thediscount. Also, under the new policy stricter credit standardswould be applied, and a tougher collection policy would beenforced. This policy has been dubbed 4/COD, net 20.
Langly likes this policy. He believes that increasing the discountwould both bring in new customers and also encourage more ofToddlers’ existing customers to take the discount. As a result, hebelieves that sales to wholesalers would increase from $15 millionto $16.5 million annually, that 60 percent of the paying customerswould take the discount, that 30 percent of the payers would pay onDay 20, that 10 percent would pay late on Day 30, and that bad debtlosses

would be reduced to 1 percent of gross sales. Langly’s is notthe only position, though. Arnold Quayle, the sales manager, hasargued for an easier credit policy. Quayle thinks that the proposedchange would result in a drastic loss of sales and profits.
Toddlers’ variable cost-to-sales ratio is 80 percent; its pre-taxcost of carrying receivables is 12 percent; and the company canexpand without any problems (or any cost increases) because it cansubcontract production that it cannot handle in-house. Further,Langly is convinced that neither the variable cost ratio nor thecost of capital would change as a result of a credit policy change.Arnold Quayle, however, thinks that the variable cost ratio mightincrease significantly if sales rise so much that the company isforced to use outside suppliers. Also, after discussions with thecost accounting staff, Quayle thinks that the variable cost ratiomight rise as high as 90 percent this coming year, even without anincrease in sales, due to higher labor costs under a contract nowbeing negotiated. Everyone agrees that there is little chance thatcosts will decline, regardless of the credit policy decision.Toddlers’ federal-plus-state tax rate is 40 percent.
Now Hardin must conduct an analysis to estimate the effect of theproposed credit policy change on Toddlers’ profitability. She andLangly are very much concerned about the analysis, both because ofits importance to the company and also because of its “politicalimplications”. The sales and production people have been lobbyingagainst any credit tightening because they do not want to take achance on losing sales and having to cut production, and alsobecause they question the assumptions Langly wants to use.Therefore, Hardin knows that her report will be critically reviewedand a thorough analysis is required. She is especially concernedabout being prepared for follow-up questions that other people,such as those in sales and production, might ask when the report isbeing reviewed. The report should consider all relevant factors,including an analysis of both the current and proposed creditpolicies and a recommendation as to what Toddlers should do.
Hardin has requested that you assist with the report. She is notcertain what risks are involved with a credit policy change or ifsuch risks can even be assessed and incorporated in the analysis.Meanwhile, Langly has expressed concern that if the firm changesits credit policy, Toddlers’ competitors may react by makingsimilar changes in their terms. Thus, Toddlers would have a newcredit policy without any change in sales.
As with every report presented to management, there probably willbe a number of questions regarding the assumptions used in theanalysis. Specifically, Hardin expects both the sales andproduction managers to question the assumptions, so she would liketo know which variables are most critical in the sense thatprofitability is very sensitive to them. No one has yet determinedjust how far off the assumptions could be before the change to atighter credit policy would be incorrect. Also, if she could,Hardin would like to have a better basis for the assumptions usedin her report - as it stands, all she has to rely on is Langly'sjudgment, which is contrary to that of two other senior executives.However, she is not sure whether any additional actions could betaken to improve the accuracy of the forecasts.
Langly gave you a portion of a letter he recently received fromIvana Tinkle, a member of Toddler's board of directors. Ivana whoalso sits on the Board of Face Cosmetics, Inc., has been involvedin numerous credit policy decisions. The decisions made by Facewere always successful from a profitability standpoint. Thus, Ivanasuggests that Toddlers use the same algebraic approach used byFace, in addition to constructing projected profit statements.Pages two and three of Ivana's letter are set forth in Exhibit 1.Ivana is a very influential member of the board, so be prepared toaddress her suggestion.
Working with Langly, she prepared the following set of questionsfor use as a guide in drafting her report. Put yourself in herposition and answer the following questions. As you answer eachquestion, think about follow-up questions that other people, suchas those in sales and production, might ask when the report isbeing reviewed.

s an alternative to constructing profit statements, an algebraicapproach has been developed that focuses directly on the change inprofits. To use this approach, it is first necessary to define thefollowing symbols:
S0 = SN =
V =
1 – V =
k = DSO0 = DSON =B0 = BN = P0 = PN =D0 = DN = T =
current gross sales new gross sales after the change in creditpolicy. Note that SN can be greater than or less than S0. variablecosts as a percentage of gross sales. V includes production costs,inventory carrying costs, the cost of administering the creditdepartment, and all other variable costs except bad debt losses,receivables carrying costs, and the cost of giving discounts.contribution margin, or the proportion of gross sales that goestoward covering fixed costs and increasing profits cost of financing the firm’s receivables current days sales outstanding newaverage days sales outstanding after change in credit policycurrent bad debt losses as a proportion of current gross sales newbad debt losses as a proportion of new gross sales proportion ofcurrent-collected gross sales that are discount sales proportion ofnew-collected gross sales that are discount sales current discountoffered discount offered under new policy tax rate
Calculate values for the incremental change in the firm’sinvestment in receivables, ΔI, and the incremental change inafter-tax profits, DP, as follows:
Formula for ΔI if Sales Increase: ΔI = V[(DSON - DSO0)(S0/360)] +V[(DSON)(SN - S0)/360].
Formula for ΔI if Sales Decrease: ΔI = V[(DSON - DSO0)(SN/360)] +V[(DSO0)(SN - S0)/360].
Formula for ΔP: ΔP = (1 - T)(SN - S0)(1 - V) - kΔI -(BNSN - B0S0)
- [DNSNPN(1 - BN) - D0S0P0(1 - B0)].
Note that, in the profit equation, the first term {(1 - T)(SN -S0)(1 - V)} is the incremental after-tax gross profit, the secondterm {kΔI} is the incremental cost of carrying receivables, thethird term {BNSN-B0S0} is the incremental bad debt losses, and thelast term {DNSNPN(1 - BN) - D0S0P0(1 - B0)} is the incremental costof discounts taken based on the percent of discounts taken bypaying customers.
Use the equations presented here to estimate the change i profitsassociated with the new policy. I hope this provides you withenough information. I will be out of the country on business forthree months and will not be available to answer any furtherquestions on this approach.
Sincerely, Ivana Tinkle

Question 1, What are the four variables that make up a firm’scredit policy? How likely (and how quickly) are competitors torespond to a change in each variable, and is their response likelyto be the same for a change toward tightness as one towardlooseness?

2.What is Toddlers’ dollar cost of carrying receivables underthe current policy? What would be the expected cost under the newpolicy? (Use a 360 day year.)

3.Hardin expects both the sales and production managers toquestion her assumptions, so she would like to know which variablesare most critical in the sense that profitability is very sensitiveto them. Then, she would like to know just how far off herassumption could be before the change to a tighter credit policywould be incorrect. If you are using the spreadsheet model, do somesensitivity analyses, changing one variable at a time while leavingthe others at their base case values. Which variables are mostimportant in terms of their effects on profits, and how large anerror could there be in the assumptions which you regard as beingmost critical before the decision should be reversed?