Hello Tayba,
In the above context, variable cost ratio refers to variable cost being of total gross sales. For example, if gross sales are 100, variable cost is 60.
when there is a change in credit policy, variable cost turn out is directly related to decrease / increase in gross sales.
in the above example, due to change in credit policy, increase in variable cost days has an opportunity cost equivalent to increase in variable cost x cost of investing those funds.
hope this helps.
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Zeeshan Shallwani
Director/Manager
Dubai
United Arab Emirates
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Original Message:
Sent: 09-11-2020 05:40 AM
From: Tayba Al-Mehdar
Subject: Managing Current Assets | Subunit 5: Receivables Management
What is the variable cost ratio?
The following information regards a change in credit policy. The company has a required rate of return of 10% and a variable cost ratio of 60%. | Old Credit | New Credit |
| Policy | Policy |
| | |
Sales | $3,600,000 | $3,960,000 |
Average collection period | 30 days | 36 days |
The pre-tax cost of carrying the additional investment in receivables, using a 360-day year, would be | |
| |
| Answer (B) is correct.
The projected average balance in receivables under the old policy was $300,000 [$3,600,000 × (30 days ÷ 360 days)]. Under the new policy, the average balance will be $396,000 [$3,960,000 × (36 days ÷ 360 days)]. Hence, the average balance is $96,000 higher under the new policy ($396,000 – $300,000). The pre-tax cost of carrying the additional investment in receivables can be calculated as follows:Increased investment in receivables -- gross | $96,000 | Times: Variable cost ratio | × 60% | | | Increased investment in receivables -- net | $57,600 | Times: Opportunity cost of funds | × 10% | | | Incremental cost of new credit plan | $ 5,760 | | |
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Tayba Al-Mehdar
Analyst
Khobar
Saudi Arabia
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