In January 2015, Teresa Leal was named treasurer of Casa de Diseño. She decided that she could best orient herself by systematically examining each area of the company’s financial operations. She began by studying the firm’s short-term financial activities. Casa de Diseño, located in southern California, specializes in a furniture line called "Ligne Moderna." Of high quality and contemporary design, the furniture appeals to the customer who wants something unique for his or her home or apartment. Most Ligne Moderna furniture is built by special order because a wide variety of upholstery, accent trimming, and colors is available. The product line is distributed through exclusive dealership arrangements with well-established retail stores.
Casa de Diseño’s manufacturing process virtually eliminates the use of wood. Plastic and metal provide the basic framework, and wood is used only for decorative purposes.
Casa de Diseño entered the plastic-furniture market in late 2007. The company markets its plastic-furniture products as indoor–outdoor items under the brand name "Futuro." Futuro plastic furniture emphasizes comfort, durability, and practicality and is distributed through wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the firm’s sales and profits in 2014. Casa de Diseño anticipates some additions to the Futuro line and also some limited change of direction in its promotion in an effort to expand the applications of the plastic furniture.
Leal has decided to study the firm’s cash management practices. To determine the effects of these practices, she must first determine the current operating and cash conversion cycles. In her investigations, she found that Casa de Diseño purchases all its raw materials and production supplies on open account. The company is operating at production levels that preclude volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseño usually receives credit terms of net 30. An analysis of Casa de Diseño’s accounts payable showed that its average payment period is 30 days. Leal consulted industry data and found that the industry average payment period was 39 days. Investigation of six California furniture manufacturers revealed that their average payment period was also 39 days. Next, Leal studied the production cycle and inventory policies. Casa de Diseño tries not to hold any more inventory than necessary in either raw materials or finished goods. The average inventory age was 110 days. Leal determined that the industry standard, as reported in a survey done by Furniture Age, the trade association journal, was 83 days.
Casa de Diseño sells to all its customers on a net-60 basis, in line with the industry trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts receivable, that the average collection period for the firm was 75 days.
Investigation of the trade association’s and California manufacturers’ average showed that the same collection period existed where net-60 credit terms were given Where cash discounts were offered, the collection period was significantly shortened. Leal believed that if Casa de Diseño were to offer credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.
Casa de Diseño was spending an estimated $26,500,000 per year on operating cycle investments. Leal considered this expenditure level to be the minimum she could expect the firm to disburse during 2015. Her concern was whether the firm’s cash management was as efficient as it could be. She knew that the company paid 15 percent annual interest for its resource investment. For this reason, she was concerned about the financing cost resulting from any inefficiencies in the management of Casa de Diseño’s cash conversion cycle. (Note: Assume a 365-day year, and assume that the operating-cycle investment per dollar of payables, inventory, and receivables is the same.)
Questions:
1) If in addition to achieving industry standards for payables and inventory the firm can reduce the average collection period by offering credit terms of 3/10 net 60, what additional savings in resource investment costs will result from the shortened cash conversion cycle, assuming that the level of sales remains constant?
2)If the firm’s variable cost of the $40,000,000 in sales is 80%, determine the reduction in the average investment in accounts receivable and the annual savings that will result from this reduced investment, assuming that sales remain constant.