Accounts receivable management directly affects corporate profitability and cash flow. For example: too much money tied up in accounts receivable would be a drag down on earnings. But when the credit term run in too—tight policy, most likely company will lose the opportunity to convert marginal [or new or seasonal] customers to become bigger [or regular or loyal] customers.  You [a controller] must consider to relax [if not liberalize] the credit term; to grant credit to the marginal customers. Having existent of idle capacity is another reason to grant credit to marginal customer. But before attempting to relax the credit term, you are supposed to perform some analysis to ensure that your decision will give best value to the company. How? This post demonstrates some examples of analysis that you can perform to get the idea. Enjoy!

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Rule of Tumbes to Understand
  
The analysis involves somewhat complex, yet multi steps calculation. To make sure your analysis is accurate; have a read the following basic rule:

  • In granting credit to marginal customers, compare the profit on sales to the added cost of the receivables. That is basic key.
  • If idle capacity exists, the additional profit is the contribution margin on the sales because fixed costs are constant.
  • The additional cost on the additional receivables results from the increased number of bad debts and the opportunity cost of tying up funds in receivables for more days.

 
Let’s go ahead to the first case example. Move on…

 

Example-1

You are attempting to grant credit to marginal customers, and below are the facts that you have found about specific items the customers attempting to purchase:

  • Sales price per unit = $120
  • Variable cost per unit = $80
  • Fixed cost per unit = $15
  • Annual credit sales = $600,000
  • Collection period = 1 month
  • Minimum return = 16%

If you relax the credit policy, you estimate that:

  • Sales will increase by 40 percent.
  • The collection period on total accounts will be 2 months.
  • Bad debts on the increased sales will be 5%.

Preliminary calculations:

Current units     = $600,000/$120 = 5,000
Additional units = 5,000 x 0.4       = 2,000
The new average unit cost is now calculated:

Units x Unit cost = Total cost

 

Current units      = 5,000 x $95 = $475,000
Additional units  = 2,000 x $80 = $160,000
Total                    = 7,000          = $635,000

New average unit cost = Total cost/Units
                                        = $635,000/7,000 = $90.71

 

Since at idle capacity fixed cost remains constant, the incremental cost is only the variable cost of $80 per unit. This will result in a decline in the new average unit cost.

Advantage
Additional profitability:

Incremental sales volume units               $2,000
x Contribution margin per unit
[Selling price – variable cost]
$120 – $80 =                                              x$40
Incremental profitability                        $ 80,000

 

Disadvantage
Incremental bad debts:

Incremental units x Selling price
2,000 x $120                                       $240,000
Bad debt percentage [5%]                         x 0.05
Additional bad debts                          $  12,000

 

Opportunity cost of funds tied up in accounts receivable:

Average investment in accounts receivable after change in policy could be formulated as below:

[Credit Sales/Accounts Receivable turnover] x [Unit cost/Selling price]

 

Therefore:

[$840,000@ / 6] x [$90.71 / $120] = $105, 828
@7,000 units x $120                       = $840,000

 

Meanwhile, current average investment in accounts receivable:

[$600,000/12] x [$95/$120]

Additional investment in accounts receivable =  $66,245
Minimum return                                               =      x0.16
Opportunity cost of funds tied up                       $10,599

 

Therefore, net advantage of relaxation in credit standards:

Additional earnings                                   = $80,000
Less:
Additional bad debt losses  = $12,000
Opportunity cost                 = $10,599
                                                                 = -$22,599

Net savings                                              =    $57,401

 

Conclusion: The company may have to decide whether to extend full credit to presently limited credit customers or no-credit customers. Full credit should be given only if net profitability occurs.

But, that is when company has only single [uniform] existing credit policy. How if some different category of credit policies involved to different level of customers?

Let’s run another example follow. Read on…

 

Example-2

So, the company has three different category of credit policy: category X, Y, Z. Here is the relevant data:

 
Category     Bad debt    Collection    Credit         Increase in
                     (%)           Period           Policy         Annual Sales
                                                                           if Credit
                                                                           Restrictions
                                                                           Are Relaxed

X                   2%           30 days     Unlimited       $ 80,000
Y                   5%          40 days     Restricted       $600,000
Z                  30%          80 days     No Credit       $850,000

 

Additional information:

  • Gross profit is 25 percent of sales.
  • The minimum return on investment is 12 percent.

Which category should you extend?

Here is solution to this problem:
                                                               Category Y                       Category Z

Gross profit:
$600,000 x 0.25                                      $150,000
$850,000 x 0.25                                                                               212,500

Less: bad debts    
$600,000 x 0.05                                       -30,000            
$850,000 x 0.30                                                                              -255,000

Incremental average
investment in accounts
receivable:

40/360 x (0.75 x $600,000)    =$50,000
80/360 x (0.75 x $850,000)                                         =$141,667

Opportunity cost of
incremental investment
in accounts receivable                   x 0.12                         x    0.12
Opportunity cost                                      -6,000                              -17,000

Net earnings                                         $114,000                           $(-59,500)

 

Conclusion: category Y resulting $114,000 net earning, compare to category Z which resulting $-59,500 net earning [loss]. Therefore, obviously, credit should be extended to category Y.

 

It is worth viewing from another angle, with a different analysis of course. Let’s perform another example. Move on…

 

Example-3

You are considering liberalizing the credit policy to encourage more customers to purchase on credit. Currently, 80 percent of sales are on credit and there is a gross margin of 30 percent. Other relevant data are:

                                                     Currently                  Proposal

Sales                                             $300,000                  $450,000
Credit sales                                  $240,000                  $360,000
Collection expenses                     4% of credit-             5% of credit-
                                                     sales                         sales
Accounts receivable turnover       4.5                            3

 

Should you institute a more liberal credit policy?

An analysis of the proposal yields the following results:

Average accounts receivable balance:

[credit sales/accounts receivable turnover]

 

Expected average accounts receivable
[$360,000/3]                                                $120,000

Current average accounts receivable
[$240,000/4.5]                                             $  53,333
Increase                                                        $  65,667

Gross profit:
Expected increase in credit sales
[$360,000 – $240,000]                                 $120,000
Gross profit rate                                                x 0.30
Increase                                                        $  36,000

Collection expenses:
Expected collection expenses
[0.05 x $360,000]                                        $ 18,000
Current collection expenses
[0.04 x $240,000]                                        $   9,600
Increase                                                       $   8,400

Conclusion: Having a $8,400 increase on the Collection Expenses compare to a $36,000 increase on Gross Profit, obviously, a more liberal credit policy should be instituted.

Credit to Marginal Customer Analysis involves a somewhat complex logic, yet multiple determination [and calculation]. But it is worth time spending to maximize company’s earning.