Rob McMillan finished reading the article in the local paper, “Fuel Prices Expected to Increase into
Summer.” The article cited major factors in the crude oil spike such as Iran’s nuclear program and
overall Mideast instability. Operating as an independent fuel oil and propane distributor in rural Virginia,
this wasn’t good news for Rob. It had been a moderate winter, but wholesale fuel prices were
higher than normal. Rob grabbed the last invoice from his supplier and saw that fuel oil was priced
at \$1.964 per gallon, with trade discounts of 7/5/2.5 available. It seemed like those discounts were
not as good as in the past. McMillan Oil offers its own customers credit terms of 2/15, net/30, with
a 1% service charge on late payments. Of the \$25,000 in average fuel oil sales per month, normally
half of Rob’s sales are paid within the discount period, and only 5% incur the monthly service
charge. Rob is concerned because a number of his fuel oil customers are behind in their payments,
and he is considering some changes.
1. Using the starting price of \$1.964 per gallon, what is Rob’s net price after applying the 7/5/2.5 trade discount series using the net decimal
equivalent?
2. Rob is considering purchasing his fuel oil from a new supplier offering fuel oil at \$2.086 per gallon, but with a better trade discount series
of 10/7/4. Compared to your answers in Exercise 1, which supplier would be a better deal for his company?
3. Using the average monthly sales of \$25,000, what is the total savings enjoyed by those fuel oil customers who normally pay within the
discount period? What is the total penalty paid by those that are delinquent over 30 days?
4. Currently, only 25% of the sales volume is paid by customers who are taking advantage of the discount, and 20% of the sales are over
30 days. Using these figures, how does that change your results from Exercise 3 above? Because your answers show that Rob is presently
making more money (at least he should), why should he be concerned about the current situation? What suggestions do you have?

1. First, the net result of applying the trade discount 7/5/2.5. A discount of 7% means a reduction to  93%; 5% a reduction to  95% of 93%; and a final reduction to 97.5% after applying the other two reductions. Net reduction is the product of these: 0.93*0.95*0.975=0.8614 or 86.14%, a discount of 13.86%. Applying this to \$1.964 per gallon we get \$1.692.
2. The net result of the new supplier is 0.90*0.93*0.96=80.35% or 19.65% net discount. Apply this to \$2.086=\$1.676, slightly lower than \$1.692, so a better prospect for Rob.
3. Rob's customers get a reduction of 2% if they make a payment within 15 days of purchase. They must pay the full purchase price after that within 30 days of purchase or they will be penalised by the 1% service charge. Half of the monthly sales (\$12,500) are paid by the customers paying within the discount period of 15 days, so \$12,500 represents 98% or 0.98 of the amount that Rob would have received if there hadn't been any discount. If we call this non-discounted amount X, then 12500=0.98X, so X=12500/0.98=\$12755.10. The customers therefore make a saving of \$255.10. This is a little more than 2% saving (which would have been \$250). The remaining \$12,500 is paid by customers and 5% of this amount=\$625 incurs the 1% service charge for late payment. The service charge amount is 1% of \$625=\$6.25.
4. If S is the sales volume (monthly) then we know, because of the discount arrangement, Rob receives 0.98*S/4 (25%) = 0.245S from those customers paying within the discount period and S/5 (20%) paying within 30 days. This 20% doesn't include those paying within the discount period, but rather those paying within the time period 16 to 30 days. It would appear that 55% (100-25-20) of the sales volume is being paid after 30 days for which the penalty service charge applies. It also means that late payment encroaches into the next month. 0.55S delivers a total service charge of 0.01*0.55S=0.0055S. In terms of revenue then, Rob receives (0.245+0.2+0.0055)S=0.4505S. S is the non-discounted value of the stock Rob sells. He loses only what is paid in discount, that is, 0.25*0.02S=0.005S and, assuming he is eventually paid by his customers, he should receive 0.995S a month. Within that month he should receive payment from late payers from the previous month or earlier, just as in later months he receives late payments applying to the current month. The problem he has is that late payments affect his own ability to purchase fuel and other goods and commodities. The service charge penalties for late payment do not contribute very much to his revenue.

Rob could encourage his customers to make prompt payment by offering a higher discount for payment within 15 days and by increasing the penalty for late payment. Although, based on current stats, he would lose more in discounts and gain more in penalties, he may be able to better ensure that he improves his purchasing ability to keep his stock at an acceptable level. He may be able in this way to reduce the percentage of late-paying customers.

by Top Rated User (1.1m points)