RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later

RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later

date, it creates accounts receivable. By allowing customers to pay some time after they receive the goods or services, you are granting credit, which we refer to as trade credit. Trade credit, also referred to as mer- chandise credit or dealer credit, is an informal credit arrangement. Unlike other forms of credit, trade credit is not usually evidenced by

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notes, but rather is generated spontaneously: Trade credit is granted when a customer buys goods or services.

Reasons for Extending Credit Firms extend credit to customers to help stimulate sales. Suppose you

offer a product for sale at $20, demanding cash at the time of the sale. And suppose your competitor offers the same product for sale, but allows customers 30 days to pay. Who’s going to sell the product? If the product and its price are the same, your competitor, of course. So the benefit from extending credit is the profit from the increased sales.

Extending credit is both a financial and a marketing decision. When

a firm extends credit to its customers, it does so to encourage sales of its goods and services. The most direct benefit is the profit on the increased sales. If the firm has a variable cost margin (that is, variable cost/sales) of 80%, then increasing sales by $100,000 increases the firm’s profit before taxes by $20,000. Another way of stating this is that the contri- bution margin (funds available to cover fixed costs) is 20%: For every $1 of sales, 20 cents is available after variable costs.

The benefit from extending credit is: Benefit from extending credit

(20-1) = Contribution margin × Change in sales If a firm liberalizes its credit it grants to customers, increasing sales

by $5 million and if its contribution margin is 25%, the benefit from liberalizing credit is 25% of $5 million, or $1.25 million.

Costs of Credit But like any credit, it has a cost. The firm granting the credit is forgoing

the use of the funds for a period—so there is an opportunity cost associ- ated with giving credit. In addition, there are costs of administering the accounts receivable—keeping track of what is owed. And, there is a chance that the customer may not pay what is due when it is due.

The Cost of Discounts Do firms grant credit at no cost to the customer? No, because as we just

explained, a firm has costs in granting credit. So they generally give credit with an implicit or hidden cost:

■ The customer that pays cash on delivery or within a specified time thereafter—called a discount period—gets a discount from the invoice price.

Management of Receivables and Inventory

■ The customer that pays after this discount period pays the full invoice price.

Paying after the discount period is really borrowing. The customer pays the difference between the discounted price and the full invoice price. How much has been borrowed? A customer paying in cash within the discount period pays the discounted price. So what is effectively bor- rowed is the cash price.

In analyses of credit terms, the dollar cost to granting a discount is: Cost of discount

(20-2) = Discount percentage × Credit sales using discount If a discount is 5% and there are $20 million credit sales using the dis-

count, the cost of the discount is 5% of $20 million, or $1 million. But wait. Is this the only effect of granting a discount? Only if you assume that when the firm establishes the discount it does not adjust the full invoice price of their goods. But is this reasonable? Probably not. If the firm decides to alter its credit policy to institute a discount, most likely it will increase the full invoice sufficiently to be compensated for the time value of money and the risk borne when extending credit.

The difference between the cash price and the invoice price is a cost to the customer—and, effectively, a return to the firm for this trade credit. Consider a customer that purchases an item for $100, on terms of 2/10, net 30. This means if they pay within 10 days, they receive a 2% discount, paying only $98 (the cash price). If they pay on day 11, they pay $100. Is the seller losing $2 if the customer pays on day 10? Yes and no. We have to assume that the seller would not establish a dis- count as a means of cutting price. Rather, a firm establishes the full invoice price to reflect the profit from selling the item and a return from extending credit. 1

Suppose the Discount Warehouse revises its credit terms, which had been payment in full in 30 days, and introduces a discount of 2% for accounts paid within 10 days. And suppose Discount’s contribution margin is 20%. To analyze the effect of these changes, we have to project the increase in Discount’s future sales and how soon Discount’s customers will pay.

1 If the customer pays within the discount period, there is a cost to the firm—the op- portunity cost of not getting the cash at the exact date of the sale but rather some

time later. With the terms 2/10 net 30, if the customer pays on the tenth day, the sell- er has just given a 10-day interest-free loan to the customer. This is part of the car- rying cost of accounts receivable, which we will discuss in a moment.

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Let’s first assume that Discount does not change its sales prices. And let’s assume that Discount’s sales will increase by $100,000 to $1,100,000, with 30% paying within ten days and the rest paying within thirty days. The benefit from this discount is the increased contribution toward before tax profit of $100,000 × 20% = $20,000. The cost of the discount is the forgone profit of 2% on 30% of the $1.1 million sales, or $6,600.

Now let’s assume that Discount changes its sales prices when it institutes the discount so that the profit margin (available to cover the firm’s fixed costs) after the discount is still 20%:

Contribution margin 1 0.02 ( – ) = 20%

Contribution margin = 20.408%

= -------------------------

If sales increase to $1.1 million, the benefit is the difference is the profit, Before the discount = 20% of $1,000,000

= $200,000 After the discount = 20.408% of $1,100,000 = $224,488

so the incremental benefit is $24,488. And the cost, in terms of the dis- counts taken is 2% of 30% of $1,100,000, or $6,600.

While we haven’t taken into consideration the other costs involved (such as the carrying cost of the accounts and bad debts), we see that we get a different picture of the benefits and costs of discounts depending on what the firm does to the price of its goods and services when the discount is instituted. So what appears to be the “cost” from the discounts doesn’t give us the whole picture, because the firm most likely changes its contri- bution margin at the same time to include compensation for granting credit. In that way, it increases the benefit from the change in the policy.

Other Costs There are a number of costs of credit in addition to the cost of the dis- count. These costs include:

■ The carrying cost of tying-up funds in accounts receivable instead of investing them elsewhere. ■ The cost of administering and collecting the accounts. ■ The risk of bad debts.

The carrying cost is similar to the holding cost that we looked at for cash balances: the product of the opportunity cost of investing in accounts receivable and the investment in the accounts. The opportunity

Management of Receivables and Inventory

cost is the return the firm could have earned on its next best opportu- nity. The investment is the amount the firm has invested to generate sales. For example, if a product is sold for $100, and its contribution margin is 25%, the firm has invested $75 in the sold item (in raw mate- rials, labor, and other variable costs).

Suppose a firm liberalizes its credit policy, resulting in an increase in accounts receivable of $1 million. And suppose that this firm’s contribu- tion margin is 40% (which means its variable cost ratio is 60%). The firm’s increased investment in accounts receivable is 60% of $1 million, or $600,000. If the firm’s opportunity cost is 5%, the carrying cost of accounts receivable is:

Carrying cost of accounts receivable = 5% of $600,000 = $30,000 We can state the carrying cost more formally as:

Carrying cost of accounts receivable = ( Opportunity cost ) Variable cost ratio ( )

(20-3) ( Change in accounts receivable )

In addition to the carrying cost, there are costs of administering and collecting accounts. Extending credit involves recordkeeping. Moreover, costs are incurred in personnel and paperwork to keep track of which cus- tomers owe what amount. In addition to simply recording these accounts, there are expenses in collecting accounts that are past due. Whether the firm collects its own accounts or hires a collection agency to collect these accounts, there are costs involved in making sure that customers pay.

Still another cost of trade credit is unpaid accounts—bad debts. If the firm demanded cash for each sale, there would be no unpaid accounts. By allowing customers to pay after the sale, the firm is taking on risk that the customer will not pay as promised. And by liberalizing its credit terms (for example, allowing longer to pay) or to whom it extend credit, the firm may attract customers who are less able to pay their obligations when promised.