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 length of the average collection period, and the required return on investment. Suppose that a firmâ€™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 per unit for each additional unit sold is the selling price less variable costs involved in producing an additional unit, or $10 — $8 = $2.
Presently, annual credit sales are running at a level of $2.4 million, and there is no underlying growth trend in such credit sales. The firm may liberalize credit, which will result in an average collection period of two months for new customers. Existing customers are not expected to alter their payment habits. The relaxation in credit standards is expected to produce a 25% increase in sales, to $3 million annually. The $600,000 increase represents 60,000 additional units if we assume that the price per unit stays the same. Finally, assume that the firmâ€™s opportunity cost of carrying the additional receivables is 20% before taxes.
This information reduces our evaluation to a trade-off between the added expected profitability on the additional sales and the opportunity cost of the increased investment in receivables. The increased investment arises solely from new, lower-paying customers. We have assumed that existing customers continue to pay in 1 month. With additional sales of $600,000 and a receivable turnover of six times a year for new customer (12mnths 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, $ 0.80 of every $1 in sales represents variable costs. Therefore, the added investment in receivables is 0.80 x $100,000 = $80,000. With these inputs, we are able to make the calculation shown below. The profitability on additional sales, $2 x 60,000 = $120,000, far exceeds the required return on the additional investment in receivables, 0.20 x $80,000 = $16,000, the firm would be well advised to relax its credit standards. An optimal policy would involve extending credit more liberally until the marginal profitability on additional sales equals the required return on the additional investment in receivables necessary to generate those sales. However, as we take on poorer credit risks, we also increase the risk of the firm reflected in the variance of the firmâ€™s expected cash-flow stream. This increasing in risk also manifests itself in additional bad-debt losses, a subject we deal with shortly.
Profitability versus required return in evaluating a credit standard change:
Profitability of additional sales = (Contribution margin per unit) x (additional units sold) = $2 x 60,000 units = $120,000.
Additional receivables = (additional sales revenue) / (Receivable turnover for new customers) = $600,000 /6 = $100,000
Investment in additional receivables = (Variables cost per unit/Sales price per unit) x (Additional receivables) = 0.80 x $100,000 = $80,000.
Required before-tax return on additional investment = (Opportunity cost) x (Investment in additional receivables) = 0.20 x $80,000 = $16,000.