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Financial Management and Strategic Management · Management of Receivables

Evaluating Credit Policy Changes and Cash Discount

Updated 4 October 2026 · Fact-checked

Evaluating a credit policy change means comparing the extra profit from the new policy with the extra costs it brings: cost of funds locked in receivables, extra bad debts and discount cost. Adopt the policy only if the net incremental benefit is positive. Do this with a clear proposed-versus-present statement.

Understand Evaluating Credit Policy Changes and Cash Discount

A firm gives credit to raise sales. But credit has a price. Money is tied up in receivables, some customers may never pay, and a cash discount reduces the amount you collect. So every change in credit terms is a trade-off between extra profit and extra cost.

There are two common question types. In the first, the firm relaxes the credit period or standards. Sales rise, but average receivables, bad debts and collection costs also rise. In the second, the firm offers a cash discount for early payment. Customers pay faster, so receivables and funds cost fall, but the discount is a cost.

The key idea is to look only at incremental items, the difference between the proposed and present policy. Extra sales earn extra contribution, not full profit, when fixed costs do not change. Cost of funds is charged on the money actually invested in receivables, which is the cost of the sales, not the sales value, unless the question says otherwise.

The final test is simple. If incremental contribution is more than incremental costs, the policy adds value. Present the working in a side-by-side table-style list so you earn step marks even if one number is wrong.

Key rules to remember

Incremental contribution
Increase in sales × P/V ratio (or contribution per unit × extra units)
Use when fixed costs stay constant. If the question gives only profit margin on sales and says fixed costs are unchanged, convert carefully to contribution.
Average receivables
Credit sales ÷ Receivables turnover = Credit sales × Collection period ÷ 365 (or 360 as stated)
Use the day count given in the question.
Investment in receivables
Average receivables × (Variable cost ÷ Sales), or total cost basis if the question says so
Follow the question's wording. The commonly used base is the cost of sales, not the sales value.
Cost of funds locked in receivables
Investment in receivables × Required rate of return
Compute for the present and the proposed policy, then take the difference.
Bad debts
Credit sales × Bad debt %
Bad debts are on sales value. Use the rate given for each policy.
Cash discount cost
Sales × % of customers availing × Discount %
Discount is on sales value of the customers who take it.
Net incremental benefit
Incremental contribution − Incremental cost of funds − Incremental bad debts − Incremental other costs − Discount cost
Accept the proposal if positive.
Annualised cost of cash discount
[Discount % ÷ (100 − Discount %)] × [365 ÷ (Credit period − Discount period)]
Compare this with the firm's cost of funds or return. A simple (non-compounded) approximation.

How to solve Evaluating Credit Policy Changes and Cash Discount questions

Use the same layout for any credit policy or cash discount question. It keeps the working tidy and earns step marks.

  1. 1Read the question and list the present policy and the proposed policy side by side: sales, credit period, bad debt %, discount, collection cost.
  2. 2Find the incremental sales and compute incremental contribution using the P/V ratio or variable cost given.
  3. 3Compute average receivables for each policy using sales × period ÷ days in the year.
  4. 4Convert receivables to investment (usually at variable cost or total cost, as the question states) and multiply by the required return to get cost of funds for each policy.
  5. 5Compute bad debts, collection costs and discount cost for each policy.
  6. 6Find the net benefit under each policy: contribution less all costs. Then take the difference.
  7. 7State a clear decision: accept or reject, with the net incremental figure.
  8. 8For discount problems, also compute the annualised cost of discount if asked and compare it with the return or borrowing rate.

Quickest way: Total approach in two columns

When to use it: Use when the question gives numbers for both present and proposed policy and asks which is better. It is the safest for written answers.

  1. Make two columns: Present and Proposed. Fill sales, variable cost, contribution.
  2. Write bad debts, discount, and collection cost rows, then investment in receivables and cost of funds.
  3. Subtract all costs from contribution to get net benefit in each column.
  4. Compare the two totals and write the decision in one line.
  5. For MCQs, compute only the changing items (extra contribution, extra funds cost, extra bad debts) and ignore anything that stays the same. Check the answer against the options before spending time on exact decimals.

Common mistakes in Evaluating Credit Policy Changes and Cash Discount

  • Using full sales value instead of cost to compute investment in receivables.

    Students see 'average receivables' and charge the return on sales value.

    Fix: Convert receivables to the cost invested (variable or total cost as stated) before applying the required return.

  • Treating extra sales as extra profit.

    Students forget that variable costs rise with sales.

    Fix: Take only incremental contribution. Fixed costs are added only if the question says they change.

  • Charging cost of funds on incremental receivables only, but bad debts on the full sales.

    Mixing the total and incremental approaches.

    Fix: Decide first whether you use the total approach or the incremental approach and apply it to every item consistently.

  • Applying the discount to all sales when only some customers take it.

    The percentage of customers availing is overlooked.

    Fix: Discount cost = sales × % availing × discount rate. Also recompute the collection period using the weighted average.

  • Using the wrong day count or the wrong denominator in the annualised discount formula.

    Students use 100 instead of (100 − discount %), or forget to subtract the discount period.

    Fix: Write the formula first: d ÷ (100 − d) × 365 ÷ (credit period − discount period).

  • Ending without a decision.

    The arithmetic takes all the time.

    Fix: Always write one closing line: accept or reject, with the net benefit figure.

Worked examples

Example 1

A firm has annual credit sales of ₹60,00,000. Variable cost is 70% of sales. Fixed costs are unchanged. Present average collection period is 30 days and bad debts are 1% of sales. The firm proposes to extend credit so that sales rise to ₹72,00,000, collection period becomes 60 days and bad debts become 2% of sales. Required return on investment is 15%. Use a 360-day year and invest in receivables at variable cost. Should the firm adopt the proposal?

Show the solution
  1. Incremental sales = ₹72,00,000 − ₹60,00,000 = ₹12,00,000. Contribution at 30% = ₹3,60,000.
  2. Present average receivables = ₹60,00,000 × 30 ÷ 360 = ₹5,00,000. Investment at 70% = ₹3,50,000. Cost of funds at 15% = ₹52,500.
  3. Proposed average receivables = ₹72,00,000 × 60 ÷ 360 = ₹12,00,000. Investment at 70% = ₹8,40,000. Cost of funds at 15% = ₹1,26,000.
  4. Incremental cost of funds = ₹1,26,000 − ₹52,500 = ₹73,500.
  5. Present bad debts = 1% × ₹60,00,000 = ₹60,000. Proposed bad debts = 2% × ₹72,00,000 = ₹1,44,000. Incremental bad debts = ₹84,000.
  6. Net incremental benefit = ₹3,60,000 − ₹73,500 − ₹84,000 = ₹2,02,500.

Answer: Net incremental benefit is ₹2,02,500, which is positive. The firm should adopt the proposal.

Example 2

A firm has credit sales of ₹48,00,000 a year on terms net 60 days. Variable cost is 75% of sales. It proposes to offer a 2% cash discount for payment within 10 days. It expects 50% of customers to take the discount, and the rest to pay on day 60. Sales and bad debts do not change. Required return is 20%. Use a 360-day year and invest in receivables at variable cost. Is the discount worthwhile?

Show the solution
  1. Present average receivables = ₹48,00,000 × 60 ÷ 360 = ₹8,00,000. Investment at 75% = ₹6,00,000. Cost of funds at 20% = ₹1,20,000.
  2. Proposed average collection period = 50% × 10 + 50% × 60 = 35 days.
  3. Proposed average receivables = ₹48,00,000 × 35 ÷ 360 = ₹4,66,667 (approx.). Investment at 75% = ₹3,50,000. Cost of funds at 20% = ₹70,000.
  4. Saving in cost of funds = ₹1,20,000 − ₹70,000 = ₹50,000.
  5. Discount cost = ₹48,00,000 × 50% × 2% = ₹48,000.
  6. Net benefit = ₹50,000 − ₹48,000 = ₹2,000.

Answer: Net benefit is ₹2,000, which is positive but small. The firm should offer the 2% cash discount, though the gain is marginal.

Exam tips

  • Always lay out present and proposed policies side by side. Examiners give step marks for each row.
  • Read whether receivables are to be valued at sales, total cost or variable cost, and follow it exactly.
  • State the day count (360 or 365) you use if the question does not give it.
  • For discount questions, work out both the net benefit and the annualised cost of the discount when asked, and compare with the cost of funds.
  • Finish with a one-line decision. Many students lose the last mark by leaving it out.

Practice questions from Management of Receivables

Evaluating Credit Policy Changes and Cash Discount in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Evaluating Credit Policy Changes and Cash Discount: frequently asked questions

Do I use sales or cost when computing cost of funds in receivables?

Use the cost invested in receivables, usually variable cost or total cost as the question states. Charging the return on sales value overstates the cost. If the question gives no hint, state your assumption clearly.

Should I use the total approach or the incremental approach?

Both give the same decision if done correctly. The total approach shows each policy in full and then compares. The incremental approach calculates only the changes. Pick the one you find less error-prone and stay consistent.

How is the cost of a cash discount calculated?

Use discount % ÷ (100 − discount %) multiplied by 365 ÷ (credit period − discount period). It gives an annualised simple rate. If it exceeds your cost of funds, offering or taking the discount is attractive in the right context.

Are bad debts calculated on cost or on sales?

Bad debts are normally a percentage of sales, as the customer owes the sales value. Apply the rate given for each policy to its own sales figure.