Nesud Co has credit sales of $45 million per year and on average settles accounts with trade payables after 60 days. One of its suppliers has offered the company an early settlement discount of 0.5% for payment within 30 days. Administration costs will be increased by $500 per year if the early settlement discount is taken. Nesud Co buys components worth $1.5 million per year from this supplier.
From a different supplier, Nesud Co purchases $2.4 million per year of Component K at a price of $5 per component. Consumption of Component K can be assumed to be at a constant rate throughout the year. The company orders components at the start of each month in order to meet demand and the cost of placing each order is $248.44. The holding cost for Component K is $1.06 per unit per year.
The finance director of Nesud Co is concerned that approximately 1% of credit sales turn into irrecoverable debts. In addition, she has been advised that customers of the company take an average of 65 days to settle their accounts, even though Nesud Co requires settlement within 40 days.
Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are 360 days in a year.
Required:
Evaluate whether Nesud Co should accept the early settlement discount offered by its supplier.
Relevant trade payables before discount = 1,500,000 x 60/360 = $250,000
Relevant trade payables after discount = 1,500,000 x 30/360 = $125,000
Reduction in trade payables = 250,000 – 125,000 = $125,000
More quickly, reduction in trade payables = 1,500,000 x (60 – 30)/360 = $125,000
The finance needed to reduce the trade payables will increase the overdraft.
Increase in finance cost = 125,000 x 0.04 = $5,000
Administration cost increase = $500
Discount from supplier = $1,500,000 x 0.005 = $7,500
Net benefit of discount = 7,500 – 5,000 – 500= $2,000 per year
On financial grounds, Nesud Co should accept the supplier’s early settlement discount offer.
Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering Component K.
Annual demand = 2,400,000/5 = 480,000 units per year
Each month, Nesud Co orders 480,000/12 = 40,000 units
Current ordering cost = 12 x 248.44 = $2,981 per year
Average inventory of Component K = 40,000/2 = 20,000 units
Current holding cost = 20,000 x 1.06 = $21,200 per year
Total cost of current ordering policy = 2,981 + 21,200 = $24,181
Economic order quantity = (2 x 248.44 x 480,000/1.06)0.5 = 15,000 units per order
Number of orders per year = 480,000/15,000 = 32 orders per year
Ordering cost = 32 x 248.44 = $7,950 per year
Average inventory of Component K = 15,000/2 = 7,500 units
Holding cost = 7,500 x 1.06 = $7,950 per year
Total cost of EOQ ordering policy = 7,950 + 7,950 = $15,900
On financial grounds, Nesud Co should adopt an EOQ approach to ordering Component K as there is a reduction in cost of $8,281.
Critically discuss how Nesud Co could improve the management of its trade receivables.
Management of trade receivables can be improved by considering credit analysis, credit control and collection of amounts owing. Management of trade receivables can also be outsourced to a factoring company, rather than being managed in-house.
Credit analysis
Offering credit to customers exposes a company to the risk of bad debts and this should be minimised through credit analysis or assessing creditworthiness. This can be done through collecting and analysing information about potential credit customers. Relevant information includes bank references, trade references, reports from credit reference agencies, records of previous transactions with potential customers, annual reports, and so on. A company might set up its own credit scoring system in order to assess the creditworthiness of potential customers. Where the expected volume of trade justifies it, a visit to a company can be made to gain a better understanding of its business and prospects.
Credit control
The accounts of customers who have been granted credit must be monitored regularly to ensure that agreed trade terms are being followed and that accounts are not getting into arrears. An important monitoring device here is an aged trade receivables analysis, identifying accounts and amounts in arrears, and the extent to which amounts are overdue. A credit utilisation report can assist management in understanding the extent to which credit is being used, identifying customers who may benefit from increased credit, and assessing the extent and nature of a company’s exposure to trade receivables.
Collection of amounts owed
A company should ensure that its trade receivables are kept informed about their accounts, amounts outstanding and amounts becoming due, and the terms of trade they have accepted. An invoice should be raised when a sale is made. Regular statements should be sent, for example, on a monthly basis. Customers should be encouraged to settle their accounts on time and not become overdue. Offering a discount for early settlement could help to achieve this.
Overdue accounts should be chased using procedures contained within a company’s trade receivables management policy. Reminders of payment due should be sent, leading to a final demand if necessary. Telephone calls or personal visits could be made to a contact within the company. Taking legal action or employing a specialised debt collection agency could be considered as a last resort. A clear understanding of the costs involved is important here, as the costs incurred should never exceed the benefit of collecting the overdue amount.
Factoring of trade receivables
Some companies choose to outsource management of trade receivables to a factoring company, which can bring expertise and specialist knowledge to the tasks of credit analysis, credit control, and collection of amounts owed. In exchange, the factoring company will charge a fee, typically a percentage of annual credit sales. The factoring company can also offer an advance of up to 80% of trade receivables, in exchange for interest.