Customer Credit Policy Evaluation

The essential idea when evaluating credit policy is to differentiate between the excess return as a result of increased credit and the incremental cost that result of increasing credit 

Excess Return is Incremental Sales* Gross profit percentage

The incremental cost equals the final outcome, an increase in the average collection period, which is the cost of investment in receivables (credit sales), in addition to the cost of bad debts, collection expenses, and the rate of lost return on investment cost

Rate of lost return on investment cost =

It is the lost return as a result of the company's funds becoming in the form of receivables (meaning that they are credit sales and did not collect) instead of investing them and earning a return in return that investment in the sense that if the company sold a credit invoice at 50,000 pounds if the company was investing this funds at the average rate of return on investment in the market 20% additional investment in receivables, it would have been possible for them to earn to the company if it had invested it in the market or even put them into the bank as a deposit and to earn a return that is the idea of lost return on investment in receivables.

For example, it would have earned 6000 pounds, and this is the idea of ​​ lost return on investment in accounts receivables

Example

Assuming that the Sales Department submitted a request to the credit department regarding increasing the credit period of the customer X from 15 to 30 days in return for increasing the customer’s sales by 750,000 pounds from 1500,000 to 2250,000 during the fiscal period and increasing the probability of the bad debt ratio from 1% to 3%

Noting that the company's cost of sales is 70% and the required rate of return on investment is 10%, does the credit department agree or not?

Cost of investment in receivables = Investment in receivables* Variable cost ratio

Investment in receivables = Total Cost of Credit Sales during the year/ 360* Average collection period

The variable cost ratio is used because it expresses the true amount of investment in receivables

It means if your sales are 100000, for example, the variable cost ratio 50%, for example, investment in receivables = 50000, not 100000

In this example, the variable cost ratio is constant in the case of the two alternatives

The average collection period will increase from 30 to 60 days, meaning that the accounts receivable turnover ratio will decrease from 12 to 6

Current credit policy

Sales = 1500000 and cost of goods sold is 70% of sales = 1050000

So, gross profit = 1500000 - 1050000 = 450000

Proposed credit policy

Sales = 2250000 and cost of goods sold is 70% = 1575000

So, gross profit = 2250000-1575000 = 675000

So, when changing the credit policy, the gross profit increased by 225,000

But that is not why the company changes its credit policy with the customer, but rather, the cost of carrying receivables must be taken into account

Current credit policy

Cost of carrying receivables= annual sales / 360 * average collection period

= 1500000/360 * 30 = 125000

Proposed credit policy=

Cost of carrying receivables= annual sales / 360 * average collection period

= 2250000/360 * 60 = 375000

This means that the cost of carrying receivables increased by 250,000 pounds

As for, the lost return on investment in accounts receivable = 250000 * 10% = 25000

If there were bad debts as a percentage of sales, the additional bad debts resulting from the period of credit expansion and the additional debts also we will calculate their cost, the same in the collection expenses, if any include in the comparison between the current policy and the proposed policy

Net income under current credit policy= Gross profit - Cost of carrying receivables

= 450000-125000 = 350000

Net income under proposed credit policy

= 675000-375000-25000 =275000

The difference between the proposed credit policy and the current credit policy

= 350000-275000 = 75000 pounds

So, the company tends to reject the proposed to increase the credit period despite the increase in sales because there will be a high cost of carrying receivables