Establishing and Changing Credit Policies The credit decisions involve tradeoffs, the profit from the additional sales

Establishing and Changing Credit Policies The credit decisions involve tradeoffs, the profit from the additional sales

versus the costs of extending credit, as follows:

Benefits Costs

Increased profits from increased sales. The opportunity cost of funds. Administration and collection costs. Bad debts.

It is difficult to measure the benefit of extending credit or changing credit terms because there are many variables to consider: If the firm liber- alizes its credit policy, extending credit to more customers, do the costs associated with this increased credit change? Most likely. Do they change in

a predictable manner? Most likely not, because you won’t know the costs associated with these additional sales until you change the credit policy. Ideally, a firm wants to design its credit (and collection) policy so that the marginal benefits from extending credit equals its marginal cost of extending credit. At this point, the firm maximizes owners’ wealth. But the benefits and costs are uncertain. The best the firm can do in forecasting the benefits and costs from its credit and collection policies is to learn from its own experience (make changes and see what hap- pens) or from the experience of others (look at what happens when a competitor changes its policies).

Analyzing a Change in Credit and Collection Policies: An Example

Let’s look at an example of a firm changing its credit policy. All-Booked- Up Company is a wholesale distributor of books and all its sales are on credit For every book it sells, its variable costs are 70% of the sales price; in other words, its variable cost ratio is 70% (and its contribution margin is 30%). If All-Booked-Up sells $100,000 worth of books, it has $30,000 after variable costs.

2 We will see in Chapter 29 how the aging schedule is useful in formulating cash budgets.

MANAGING WORKING CAPITAL

EXHIBIT 20.1 Proposed Change in Credit Policy for All-Booked-Up

From: To:

Payment due in 30 days Payment due in 40 days Moderate collection efforts, costing 1

Intense collection efforts, costing 1 cent per dollar of accounts receivable

cent per dollar of accounts receivable for accounts paying within 40 days,

3 cents per dollar of accounts receiv- able for accounts paying beyond 40 days.

All-Booked-Up is proposing a change to its credit policy, as outlined in Exhibit 20.1. Without the changes, All-Booked-Up expects $3 million in sales and $1 million of accounts receivable; with the changes, All-Booked-Up expects sales to be $4 million and accounts receivable to be $1.5 mil- lion. But where will these extra sales come from? We assume that the additional sales will come from slower paying customers who like the new 40 day credit period.

To analyze the benefits and costs, we need to know All-Booked-Up’s opportunity cost of funds: What could they do with the funds if they didn’t have them tied up in receivables? Let’s assume that the firm’s opportunity cost of funds (on a before-tax basis) is 20%. It is important that we are consistent in dealing with all before-tax benefits and costs or all after-tax benefits and costs. Because dealing with the before-tax ben- efits and costs saves us the adjustment for taxes, let’s stick with these to make our analysis simpler.