Credit Terms

Credit Period. Credit terms involve both the length of the credit period and the discount given. The terms "2/10, net 30" mean that a 2 percent discount is given if the bill is paid before the tenth day after the date of invoice; payment is due by the thirtieth day. The credit period, then, is 30 days. Although the customs of the industry frequently dictate the terms given, the credit period is another means by which a firm may be able to affect product demand, hoping to increase demand by extending the credit period. As before, the tradeoff is between the profitability of additional sales and the required return on the additional investment in receivables.

Let us say that the firm in our example increases its credit period from 30 days to 60 days. The average collection period for existing customers goes from 1 $360,000, and these new customers also pay, on average, in 2 months. The total additional receivables are comprised of two parts. The first part represents the receivables associated with the increased sales. In our example, there are $360,000 in additional sales. With a receivable turnover of six times a year, the additional receivables associated with the new sales are $360,000/6 = $60,000. For these additional receivables, the investment by the firm is the variable costs tied up in them. For our example, we have ($8/$10)($60,000) = $48,000.

The second part of the total additional receivables represents the slowing in collections associated with original sales. The old receivables are collected in a slower manner, resulting in a higher receivable level. With $2.4 million in original sales, the firm's level of receivables with a turnover of 12 times a year is $2,400,000/12 = $200,000. The new level with a turnover of 6 times a year is $2,400,000/6 = $400,000. Thus, there are $200,000 in additional receivables associated with the original sales. For this addition, the relevant investment using marginal analysis is the full $200,000. In other words, the use of variable costs pertains only to new sales. The incremental $200,000 in receivables on original sales would have been collected earlier had it not been for the change in credit standards. Therefore, the firm must increase its investment in receivables by $200,000.

Based on these inputs, our calculations are shown in Table 15 2. The appropriate comparison is the profitability of additional sales with the opportunity cost of the additional investment in receivables. Inasmuch as the profitability on additional sales, $72,000, exceeds the required return on the investment in additional receivables, $49,600, the change in credit period from 30 to 60 days is worthwhile. The profitability of the additional sales more than offsets the added investment in receivables, the bulk of which comes from existing customers slowing their payments.

Discount Given. Varying the discount involves an attempt to speed up the payment of receivables. To be sure, the discount also may have an effect upon demand and upon bad debt losses. We assume that the discount is not regarded as a means of cutting price and thereby affecting demand, and that the discount offered does not affect the amount of bad debt losses.' Holding constant these factors, we must determine whether a speedup in collections would more than offset the cost of an increase in the discount. If it would, the present discount policy should be changed.

Suppose the firm has annual credit sales of $3 million and an average collection period of 2 months, and that the sales terms are net 45 days, with no discount given. Consequently, the average receivable balance is $500,000. By instigating terms of 2/10, net 45, the average collection period can be reduced to one month, as 60 percent of the customers (in dollar volume) take advantage of the 2 percent discount. The opportunity cost of the discount to the firm is .02 X .6 X $3 million, or $36,000 annually. The turnover of receivables has improved to 12 times a year, so that average receivables are reduced from $500,000 to $250,000.

Thus the firm realizes $250,000 from accelerated collections. The value of the funds released is their opportunity cost. If we assume a 20 percent rate of return, the opportunity saving is $50,000. In this case the opportunity saving arising from a speedup in collections is greater than the cost of the discount. The firm should adopt a 2 percent discount. If the speedup in collections had not resulted in sufficient opportunity savings to offset the cost of discount, the discount policy should not be changed. It is possible, of course, that discounts other than 2 percent may result in an even greater difference between the opportunity savings and the cost of the discount.

Seasonal Datings. During periods of slack sales, firms will sometimes sell to customers without requiring payment for some time to come. This seasonal dating can be tailored to the cash flow of the customer and may stimulate demand from customers who cannot pay until later in the season. Again, we should compare the profitability of additional sales with the required return on the additional investment in receivables to determine whether datings are appropriate terms by which to stimulate demand.

Datings also can be used to avoid inventory carrying costs. If sales are seasonal and production is steady throughout the year, there will be buildups in finished goods inventory during certain times of the year. Storage involves warehousing costs that might be avoided by giving datings. If warehousing costs plus the required rate of return on investment in inventory exceed the required rate of return on the additional receivables, datings are worthwhile.