Credit Standards

Credit policy can have a significant influence upon sales. In theory, the firm should lower its quality standard for accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables. What are the costs of relaxing credit standards? Some arise from an enlarged credit department, the clerical work of checking additional accounts, and servicing the added volume of receivables. We assume for now that these costs are deducted from the profitability of additional sales to give a net profitability figure for computational purposes. Another cost comes from the increased probability of bad debt losses. We postpone consideration of this cost to a subsequent section; we assume for now that there are no bad debt losses.

Finally, there is the opportunity cost of the additional receivables, resulting from (1) increased sales and (2) a slower average collection period. If new customers are attracted by the relaxed credit standards, collecting from these customers is likely to be slower than collecting from existing customers. In addition, a more liberal extension of credit may cause certain existing customers to be less conscientious in paying their bills on time.

To assess the profitability of a more liberal extension of credit, we must know the profitability of additional sales, the added demand for products arising from the relaxed credit standards, the increased slowness of the average collection period, and the required return on investment. Suppose that a firm's product sells for $10 a unit, of which $8 represents variable costs before taxes, including credit department costs. The firm is operating at less than full capacity, and an increase in sales can be accommodated without any increase in fixed costs. Therefore, the contribution margin of an additional unit of sales is the selling price less variable costs involved in producing the unit, or $10 $8 = $2.

At present, annual credit sales are running at a level of $2.4 million, and there is no underlying trend in such sales. The firm may liberalize credit, which will result in an average collection experience of new customers of 2 months.' Existing customers are not expected to alter their payment habits and continue to pay in 1 month. The relaxation in credit standards is expected to produce a 25 percent increase in sales, to $3 million annually.' This $600,000 increase represents 60,000 additional units if we assume that the price per unit stays the same. Finally, assume that the opportunity cost of carrying the additional receivables is 20 percent before taxes.

This information reduces our evaluation to a tradeoff between the added profitability on the additional sales and the opportunity cost of the increased investment in receivables. The increased investment arises solely from new, slower paying customers; we have assumed existing customers continue to pay in 1 month. With the additional sales of $600,000 and receivable turnover of 6 times a year (12 months divided by the average collection period of 2 months), the additional receivables are $600,000/6 = $100,000. For these additional receivables, the firm invests the variable costs tied up in them. For our example, $.80 of every $1.00 in sales represents variable costs. Therefore, the added investment in receivables is .80 X $100,000 = $80,000. In as much as the profitability on additional sales, $120,000, far exceeds the required return on the additional investment in receivables, $16,000, the firm would be well advised to relax its credit standards. An optimal credit policy would involve extending trade credit more liberally until the marginal profitability on additional sales equals the required return on the additional investment in receivables.

Some Qualifications - Obviously there are many practical problems in effecting a change in credit policy, particularly in estimating the outcomes. In our example, we have worked with only the expected values of additional demand and of the slowing of the average collection period. It is possible and desirable to attach probability distributions to the increased demand and to the increased slowness in receivables and to evaluate a range of possible outcomes. For simplicity of discussion, we shall not incorporate these dimensions into our example. Another assumption is that we can produce 60,000 additional units at a variable cost of $8 a unit; that is, we do not have to increase our plant. After some point, we are no longer able to meet additional demand with existing plant and would need to add plant. This occurrence would necessitate a change in analysis, for there would be a large block of incremental costs at the point where the existing plant could produce no more units. One implication to all this is that the firm should vary its credit quality standards in keeping with the level of production. As capacity is approached, quality standards might be increased. When production sags and the firm operates at a level below capacity, the lowering of credit quality standards becomes more attractive, all other things the same.

The credit standards of the firm may affect the level of inventories maintained. Easier standards leading to increased sales may require more inventories. In order to correct for this overstatement, the additional inventories associated with a new credit policy should be added to the additional receivables, and the opportunity cost should be computed on the basis of the combined increase. Our analysis also implies that the conditions described will be permanent. That is, increased demand as a function of lowering credit quality standards as well as price and cost figures will remain unchanged. If the increase in sales that results from a change in credit policy were a one shot as opposed to a continuing occurrence, we would need to modify our analysis accordingly.