Bluegrass Distilleries, Inc. refuses to extend credit to any wholesale distributors who have a history of being delinquent in repaying credit extended to them. This policy results in lost sales of $10 million annually. Based on experience with these types of customers, the firm estimates that the average collection period would be 90 days and that the bad-debt loss ratio would be 6%. The firm's variable cost ratio is 0.80, making its profit contribution ratio 0.20. Bluegrass Distilleries' required pretax return (i.e., opportunity cost) on receivables investments is 20%. When converting from annual to daily data or vice versa, assume there are 365 days per year. Assuming Bluegrass extends full credit to these (previously delinquent) customers, determine the total increase in credit-related costs.
A) $1,000,000
B) $1,093,151
C) $400,000
D) $600,000

Question

Quizplus · Accepted Answer

First, we need to calculate the increase in credit-related costs if Bluegrass extends credit to previously delinquent customers.

Increase in credit-related costs = (Cost of credit sales x Bad debt loss ratio) + (Opportunity cost x Average collection period x Variable cost ratio)

Cost of credit sales = $10 million 
Bad debt loss ratio = 6% 
Opportunity cost = 20% 
Average collection period = 90 days 
Variable cost ratio = 0.80

Plugging these values into the formula:

Increase in credit-related costs = ($10,000,000 x 0.06) + (0.20 x 90/365 x $10,000,000 x 0.80)

Increase in credit-related costs = $600,000 + $493,151

Increase in credit-related costs = $1,093,151

Therefore, the total increase in credit-related costs if Bluegrass extends credit to previously delinquent customers is $1,093,151. Thus, the correct answer is B.