Bailey Distributing Company sells small appliances to hardware stores in the southern California area. Michael Bailey, the president of the company, is thinking about changing the credit policies offered by the firm to attract customers away from competitors. The current policy calls for a 1/10, net 30, and the new policy would call for a 3/10, net 50. Currently 40 percent of Bailey customers are taking the discount, and it is anticipated that this number would go up to 50 percent with the new discount policy. It is further anticipated that annual sales would increase from a level of $200,000 to $250,000 as a result of the change in the cash discount policy.

The increased sales would also affect the inventory level. The average inventory carried by Bailey is based on a determination of an EOQ. Assume unit sales of small appliances will increase from 20,000 to 25,000 units. The ordering cost for each order is $100 and the carrying cost per unit is $1 (these values will not change with the discount). The average inventory is based on EOQ/2. Each unit in inventory has an average cost of $6.50.

Cost of goods sold is equal to 65 percent of net sales; general and administrative expenses are 10 percent of net sales; and interest payments of 12 percent will be necessary only for the increase in the accounts receivable and inventory balances. Taxes will equal 25 percent of before-tax income.

         a.      Compute the accounts receivable balance before and after the change in the cash discount policy. Use the net sales (Total sales – Cash discounts) to determine the average daily sales and the accounts receivable balances.

         b.      Determine EOQ before and after the change in the cash discount policy. Translate this into average inventory (in units and dollars) before and after the change in the cash discount policy.

         c.      Complete the income statement.


Before Policy Change

After Policy Change

Net sales (Sales – Cash discounts)



Cost of goods sold



Gross profit



General and administrative



Operating profit



Interest on increase in accounts
   receivable and inventory (12%)



Income before taxes






Income after taxes



         d.      Should the new cash discount policy be utilized? Briefly comment.

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