Explain the rational for each of the four variables that make up the fimrss credit policy. How likely ( and how quickly) are competitors to respond to a change in each variable and is their response likely to be the same for a change towards tightness as one towards looseness? Show less
state Show more Lifeline Health Products is a distributor of dietary supplements and home health aids. Lifeline started in the mid 1960s in southern New Hampshire as a mail order company primarily marketing its products through targeted mailing lists. The company was one of the early leaders in webbased marketing and sales. At the same time the general population was becoming more health conscious and looking for health maintenance alternatives and as a result sales soared. Eventually Lifeline became a recognized brand name with very loyal customers. By the 1990s public interest in their products was high and a number of retail stores approached the company about the possibility of stocking their products. More recently one of the large alternative nutrition chains became a retail outlet for their dietary supplements. When Lifelines sales were mail order the company did not have to worry about its overall credit policy. The primary method of paying for incoming orders was through check or credit card and very few customers checks were returned for insufcient funds. The adjustment to becoming a wholesaler for retail outlet stores however represented a signicant change. The expansion and the increased complexity of sales required increasing administrative staff and Lifeline hired Lisa Freeland as its financial manager. One of her early tasks was to evaluate the companys credit terms for wholesale customers in keeping with industry practices of offering credit with cash discounts for early payment. Lifelines current credit terms are 1.5/15 net 45 meaning that wholesalers receive a 1.5 percent discount off the gross purchase price for payments received within fteen days with payment due in full in forty-ve days for wholesale customers who do not take the discount. The company checks the nancial strength of potential customers although standards for granting credit are not high. Lifeline has procedures for collecting past-due accounts but the collections policy could best be described as passive. Under this credit policy gross sales to wholesalers average about $25 million a year with 34 percent of the paying wholesalers taking the discount and pay on average on day 15. Another 43 percent of the payers generally pay the full amount on day 45 while 23 percent tend to stretch Lifelines terms such that the average payment (including bad debt write-offs) averages sixty days. One and one-half percent of Lifelines gross sales to wholesalers end up as bad debt losses. Although the terms appear to work well Lisa was concerned that the anticipated increase in sales volume to a major chain would create cash ow problems for the company. She noted that some of their existing customers were stretching payments beyond the allowable terms. She thought that prompt payment by these customers could prevent potential cash ow problems. Also she was concerned that bad debt was eroding company prots. With these issues in mind Lisa talked to Ursula Brandywine the companys president about reviewing the companys current credit policy and possibly recommending changes. Brandywine agreed the companys credit policy needed a thorough review and is convinced that the policy should be tightened Brandywine [believes that good customers will pay on time regardless of the terms and the ones who would complain about a ti ghtcr policy are probably good customers. She also noted that with a 25 percent prolit margin. each dollar in bad debt requires three dollars of new sales just to break even. Therefore. she asked Lisa to focus her analysis on a tighter credit policy that would speed collections and reduce bad debt. Alter reviewing industry standards and talking to several large wholesale customers Lisa feels that a 3/COD net 25 policy would be acceptable to current customers. This is a tighter policy. under which a 3 percent discount would be offered to customers who pay cash on delivery (). and twenty-ve 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 the company would implement a much stronger collection policy on late accounts. Brandywine likes this policy. She believes that increasing the discount would both bring in a few new customers and also encourage more of Lifelines existing customers to pay earlier in order to receive the higher discount. As a result. she believes that sales to wholesalers would increase from $25 million to $26.5 million annually that 47 percent of the paying wholesale customers would take the discount that 38 percent of the payers would pay on day 25. that 15 percent would pay late on average in forty-two days and that bad debt losses would be reduced to 1 percent of gross sales. In contrast to Brandywines enthusiasm for the change Ben Gumsy the sales manager has long argued for easing credit policy. Ben thinks that tightening the credit standards and collection process will result in a drastic loss of sales and profits. Lifelines variable cost-to-sales ratio is 75 percent its pre-tax cost of carrying receivables is 11 percent and its federal-plus-state tax rate is 36 percent. Brandywine is convinced that neither the variable cost ratio nor the cost of capital would change as a result of a credit policy change. Ben Gumsy however thinks that the variable cost ratio might increase signicantly since the company is renegotiating terms with its current suppliers. In fact Ben thinks that the variable cost ratio might rise as high as 85 percent this coming year even without any change in policy. Although everyone agrees that there is little chance that costs will decline it is always a remote possibility. Now Lisa must conduct an analysis to estimate the effect of the proposed credit policy change on Lifelines protability. She is very concerned about the analysis both because of its importance to the companys cash position and also because of its internal political implications since the sales and production people have been lobbying against any credit tightening. They do not want to take a chance on losing sales and reducing their commissions. Lisa plans to write a report that includes an analysis of both the current and proposed credit policies and a recommendation as to what the company should do. Because the actual impact is uncertain she knows that her report will be critically reviewed and she believes that Ben will question her assumptions. She is also concerned about possible follow-up questions from other people such as those in marketing and production and therefore she knows that the report must address all relevant factors and explain which variables are most critical or sensitive to the companys protability. It is important to understand just how far off the assumptions could be before her recommendation would be incorrect. Lisa has requested your assistance with the report and would like your input as to the risk that might be involved with a credit policy change and if so how these types of risk can be incorporated into the analysis. Another concern that must be addressed is how the companys competitors may react. If they make similar changes Lifeline would have a new credit policy without any change in sales. help with the analysis Brandywine gave Lisa a report she recently received from Rick Sales an inuential member of the Board of Directors. Rick recently conducted a credit analysis for his company that resulted in improved profitability. Portions of the report are set forth in Exhibit 1. Brandywine has suggested that Lisas analysis use the same algebraic approach in addition to constructing projected profit statements. You must analyze the change in credit policy and prepare a written report to present at the companys quarterly staff meeting. Lisa has prepared the following set of questions for use as a guide in drafting her report. Put yourself in her position and answer the following questions. As you answer each question think about follow-up questions that other people such as those in 53135 and production might ask when the report is being reviewed. Question: Explain the rational for each of the four variables that make up the fimrss credit policy. How likely ( and how quickly) are competitors to respond to a change in each variable and is their response likely to be the same for a change towards tightness as one towards looseness? Show less
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