Questions:
Our software solutions company has a revenue of $28 million and all sales are made on 30 days credit. The average trade receivables balance is $5.37 million and usually, 2% of the credit sales are bad debts. 

We have been trying to reduce the collection period of debts and have spent huge amounts of money but in vain. A factoring company provided us the following option:

Administration by the factor of our invoicing, sales accounting and receivables collection, on a full recourse basis. The factor would charge a service fee of 0.5% of credit sales revenue per year. We estimate that this would result in savings of $30,000 per year in administration costs. Under this arrangement, the average trade receivables collection period would be 30 days.

Perform a cost/benefit analysis of this option.

We received an alternative option:

Administration by the factor of our invoicing, sales accounting and receivables collection on a non-recourse basis. The factor would charge a service fee of 1.5% of credit sales revenue per year. Administration cost savings and average trade receivables collection period would be as Option 1. We would be required to accept an advance of 80% of credit sales when invoices are raised at an interest rate of 9% per year. We pay interest on our overdraft at a rate of 7% per year and the company operates for 365 days per year.

Should we pursue this instead?

Reference answers:
# Option 1

## Benefits
Current trade receivables = $5370000

Revised trade receivables = $28000000 * 30/365 = $2301370 
(With factoring, the average trade receivables balance will be reduced to $2,301,370. This is derived from the 30-day collection period, assuming the same annual sales)

Reduction in receivables = $5370000 - $2301370 = $3068630

Reduction in financing costs = $3068630 * 0.07 = $214804
(The reduction in financing costs due to reduced receivables, assuming an overdraft interest rate of 7%)

Reduction in admin costs = $30000

Total benefits = $214804 + $30000 = $244804

## Costs
Factor's fee = $28000000 * 0.5% = $140000
(The factor charges a fee of 0.5% of the annual credit sales)

## Net Benefits
Net benefit = Total benefits - Total costs
Net benefit = $244804 - $140000 = $104804

The net benefit of this option would be $104,804.

# Benefits
Reduction in financing cost = $3068630 * 0.07 = $214804 
Reduction in admin costs  =  $30000 
Bad debts saved = $28000000 * 0.02 = $560000 
(Under non-recourse factoring, the factor assumes the bad debts risk, saving the company 2% of the annual credit sales)

Benefits = $214804 + $30000 + $560000 = $804804 

# Costs

Increase in finance cost = $2301370 * 80% * (9%-7%) = $36822 
(The factor advances 80% of the credit sales at an interest rate of 2% (the different between offered interest rate of 9% and the current financing cost of 7%). However, we should only consider the cost of financing the remaining receivables after considering the advance. The interest is calculated on the advanced amount)

Factor's fee = $28000000 * 1.5% = $420000 
(The factor charges a fee of 1.5% of the annual credit sales)

Costs = $36822 + $420000 = $456822  

## Net Benefit
Net benefit = Benefits - Costs
Net benefit = $804804 - $456822 = $347982 


This option is better, since it provides a higher net benefit.