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Financial Management and Business Data Analytics · Receivable Management

Evaluating Credit Policy and Cash Discount Decisions

Updated 10 October 2026 · Fact-checked

Evaluating a credit policy or cash discount means comparing the current and proposed policy line by line. Work out the extra contribution, then deduct the extra cost of funds locked in receivables, extra bad debts and discounts allowed. If the net incremental profit is positive, accept the change.

Understand Evaluating Credit Policy and Cash Discount Decisions

A firm sells on credit to win more sales. But credit has a price. Money is stuck in receivables, some customers never pay, and collection takes effort. Every change in credit terms, such as a longer credit period or a cash discount, moves these costs and the sales volume at the same time.

The method is incremental analysis. You do not judge each policy in isolation. You list the benefits and costs under the current policy and under the proposed policy, then look at the difference. The benefit is the extra contribution from extra sales. The costs are the extra investment in receivables (and the return you could earn on it), the extra bad debts, and any cash discount you now give.

A cash discount such as 2/10 net 30 means the buyer may deduct 2% if it pays within 10 days. Otherwise the full amount is due in 30 days. For the seller, the discount is a cost. In return, it shortens the average collection period, so less money is tied up, and it may lower bad debts and raise sales. The decision is whether those gains exceed the discount cost.

Investment in receivables is usually measured at variable cost, not at selling price. The profit part of a sale has not been spent in cash. Only the cost you actually paid out is blocked. Use the total cost only if the question says so. Then multiply the investment by the required rate of return to get the cost of carrying receivables.

Finally, always read what the question gives you: the days in a year (360 or 365), whether bad debts are a percentage of all sales or only of new sales, and what share of customers take the discount.

Key rules to remember

Cost of cash discount (annualised, simple)
[d ÷ (100 − d)] × [365 ÷ (credit period − discount period)]
d is the discount percentage. For 2/10 net 30: 2/98 × 365/20 = 37.24%. Use 360 days if the question says so.
Cost of cash discount (effective, compound)
(1 + d ÷ (100 − d))^(365 ÷ (N − D)) − 1
N is the credit period and D the discount period. Use only if the question asks for the effective rate. For 2/10 net 30 it is about 44.6%.
Average receivables
(Credit sales ÷ days in year) × average collection period
This gives receivables at selling price.
Investment in receivables
Average receivables × variable cost ratio
Use the total cost ratio only if the question tells you to.
Cost of carrying receivables
Investment in receivables × required rate of return
Compute it for both policies and take the difference.
Bad debts
Bad debt % × credit sales
Check whether the percentage applies to all sales or only to the incremental sales.
Cost of discount allowed
Discount % × proportion of customers availing × credit sales
Applied to the sales figure of the proposed policy.
Net incremental profit
Incremental contribution − incremental carrying cost − incremental bad debts − discount cost
Positive means accept the proposal. Savings in carrying cost or bad debts are added.

How to solve Evaluating Credit Policy and Cash Discount Decisions questions

Use the same layout for every question on credit terms or discounts. It earns step marks and avoids missed items.

  1. 1Note the basics: days in year, variable cost ratio, required return and the base case figures (sales, collection period, bad debt %).
  2. 2Write down the current policy and the proposed policy in two columns: sales, collection period, bad debt % and discount details.
  3. 3Calculate contribution for both policies (sales × contribution ratio). Find the incremental contribution.
  4. 4Calculate average receivables for both policies using sales ÷ days × collection period. Convert to investment at variable cost.
  5. 5Calculate the cost of carrying receivables at the required return for both policies and find the difference.
  6. 6Calculate bad debts for both policies. Calculate the discount cost for the proposed policy.
  7. 7Combine: incremental contribution − extra carrying cost − extra bad debts − discount cost. Treat savings as positive items.
  8. 8State the conclusion in words: accept if net incremental profit is positive, reject if negative. Mention the figure.

Quickest way: Total approach: net benefit of each policy

When to use it: Use when the question gives complete figures for both policies and asks only whether to adopt the new one. It also works well when a discount is part of the proposal.

  1. For each policy, compute one number: contribution − carrying cost − bad debts − discount.
  2. Subtract the current policy's number from the proposed policy's number.
  3. If you have time, check by computing the incremental items separately. Both answers must match.
  4. Write the layout in a clear table-like list so the examiner can see each item.

Common mistakes in Evaluating Credit Policy and Cash Discount Decisions

  • Measuring investment in receivables at selling price

    Receivables are shown in the books at the sale value, so students use sales ÷ 360 × days directly.

    Fix: Multiply average receivables by the variable cost ratio unless the question says otherwise. Then apply the required return.

  • Applying the discount to all customers

    Students forget the given percentage of customers who actually take the discount.

    Fix: Discount cost = discount % × share of customers availing × credit sales.

  • Treating bad debts as a percentage of only the extra sales

    The question's wording is not read carefully, so the proposed policy's bad debt rate is applied to the increment only.

    Fix: Check the wording. If the new rate applies to all sales, compute bad debts on total sales for both policies and take the difference.

  • Using the profit figure instead of contribution for extra sales

    Fixed costs are assumed to rise with sales, although they usually do not within the relevant range.

    Fix: Use contribution (sales − variable cost) for incremental benefit unless the question says fixed costs also change.

  • Mixing 360 and 365 days

    The cost of discount formula is memorised with 365, while the receivables part of the question uses 360.

    Fix: Use whichever the question states, and use it everywhere in that answer. If nothing is stated, 365 is a safe default; state your assumption.

  • Giving a number without a decision

    Students stop once the arithmetic ends.

    Fix: End with a sentence: the net incremental profit is ₹X, so the proposal should be accepted (or rejected).

Worked examples

Example 1

A firm has annual credit sales of ₹1,00,00,000, a contribution ratio of 20% (variable cost 80%), an average collection period of 30 days and bad debts of 1% of sales. It proposes to extend credit so that the collection period becomes 60 days. Sales will rise to ₹1,20,00,000 and bad debts will be 2.5% of all sales. The required return on investment is 18%. Use 360 days. Should the firm extend credit?

Show the solution
  1. Current contribution = 20% × 1,00,00,000 = ₹20,00,000. Proposed contribution = 20% × 1,20,00,000 = ₹24,00,000. Incremental contribution = ₹4,00,000.
  2. Current receivables = 1,00,00,000 ÷ 360 × 30 = ₹8,33,333. Investment at variable cost (80%) = ₹6,66,667.
  3. Proposed receivables = 1,20,00,000 ÷ 360 × 60 = ₹20,00,000. Investment at 80% = ₹16,00,000.
  4. Carrying cost at 18%: current = 6,66,667 × 18% = ₹1,20,000. Proposed = 16,00,000 × 18% = ₹2,88,000. Incremental carrying cost = ₹1,68,000.
  5. Bad debts: current = 1% × 1,00,00,000 = ₹1,00,000. Proposed = 2.5% × 1,20,00,000 = ₹3,00,000. Incremental bad debts = ₹2,00,000.
  6. Net incremental profit = 4,00,000 − 1,68,000 − 2,00,000 = ₹32,000.

Answer: Net incremental profit is ₹32,000, which is positive. The extension is marginally acceptable. A small rise in the bad debt rate or the collection period would turn it negative, so the margin of safety is thin.

Example 2

Sundaram Traders has credit sales of ₹6,00,00,000, with an average collection period of 45 days and bad debts of 1.5% of sales. Variable cost is 70% of sales and the required return is 15%. It proposes terms of 2/10 net 30. Sales are expected to rise to ₹6,60,00,000, 60% of customers will take the discount, the average collection period will fall to 20 days and bad debts will fall to 1% of sales. Use 360 days. (a) Find the annualised cost of the discount to the buyer, using 365 days. (b) Advise whether the firm should adopt the terms.

Show the solution
  1. (a) Cost of discount = 2 ÷ 98 × 365 ÷ (30 − 10) = 0.020408 × 18.25 = 37.24% approximately.
  2. (b) Incremental contribution: current = 30% × 6,00,00,000 = ₹1,80,00,000. Proposed = 30% × 6,60,00,000 = ₹1,98,00,000. Increase = ₹18,00,000.
  3. Current receivables = 6,00,00,000 ÷ 360 × 45 = ₹75,00,000. Investment at 70% = ₹52,50,000. Carrying cost at 15% = ₹7,87,500.
  4. Proposed receivables = 6,60,00,000 ÷ 360 × 20 = ₹36,66,667. Investment at 70% = ₹25,66,667. Carrying cost at 15% = ₹3,85,000.
  5. Saving in carrying cost = 7,87,500 − 3,85,000 = ₹4,02,500.
  6. Bad debts: current = 1.5% × 6,00,00,000 = ₹9,00,000. Proposed = 1% × 6,60,00,000 = ₹6,60,000. Saving = ₹2,40,000.
  7. Discount cost = 2% × 60% × 6,60,00,000 = ₹7,92,000.
  8. Net benefit = 18,00,000 + 4,02,500 + 2,40,000 − 7,92,000 = ₹16,50,500.

Answer: (a) The discount costs the buyer about 37.24% a year if it is not taken, so buyers with cheaper funds will take it. (b) The net incremental profit is ₹16,50,500, so the firm should adopt 2/10 net 30.

Exam tips

  • Draw a two-column layout (current vs proposed) first. Most step marks come from showing each line clearly.
  • Read the bad debt wording twice: all sales or incremental sales only. It changes the answer.
  • State your assumption about days in the year and about using variable cost for investment in receivables.
  • If the question gives several alternative policies, compute the net benefit of each and rank them, then recommend the highest positive one.
  • In MCQs, the cost of discount is a quick calculation: d ÷ (100 − d) × 365 ÷ (N − D). Check whether the question wants the simple or compound rate.

Practice questions from Receivable Management

Evaluating Credit Policy and Cash Discount Decisions 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 and Cash Discount Decisions: frequently asked questions

How do I calculate the cost of cash discount 2/10 net 30?

Use [2 ÷ 98] × [365 ÷ 20]. This gives about 37.24% a year. It is the cost to the buyer of giving up the discount, and the return to the buyer of taking it.

Why is investment in receivables taken at variable cost?

The profit element of a sale is not cash you have spent. Only the variable cost is actually blocked in receivables. Use total cost only when the question instructs you to.

Do I add or subtract savings in bad debts?

If the proposed policy has lower bad debts, the saving is a benefit and is added to the incremental profit. If bad debts rise, the extra amount is deducted.

Should I use 360 or 365 days?

Use the number given in the question. If none is given, state your assumption, preferably 365, and use it consistently throughout the answer.