Evaluating profitability is an assessment requiring considerable managerial experience, insight, and judgment. It is, perhaps, easier in this area to lay out a few rules than in the area of risk assessment.
The easiest approach is to look at the ratio of profits to sales for the products the customer wants. The higher the profit on sales, the more likely you will want to grant credit to a customer of a given risk profile. Other things being equal, this is true; but other things are seldom equal. Customer A, whose credit is not as good as Customer B’s, may buy more than Customer B. Customer A may pay twice as fast as Customer B despite having some poorer ratios.
KEY POINT: In short, the extension of credit, the commitment of funds to accounts-receivable balances, is an investment decision. It is thus appropriate to apply the same measure of attractiveness used in evaluating other asset decisions: return on investment.
The use of a return-on-investment measure requires that you develop information about both the return and the investment. Often, and accounts-receivable analysis is no exception, it is unclear which figures you should use. How to measure the return shall be discussed first, followed by consideration of the problem of measuring the investment.
The most obvious return from an extra sale is the profit recorded on that sale.
KEY POINT: A sensible credit system will help you or the credit manager estimate the contribution to fixed costs and profits a sale will make rather than merely the standard profit allowed.
This approach is particularly important if the standard costs incorporate a variety of fixed costs and overhead. For a manufacturing company, the standard gross profit, less selling and delivery variable costs, is the least amount of contribution a marginal sale might make. Actual contribution is probably more because of fixed costs built into the standard costs. A retail or wholesale firm can derive a contribution estimate by deducting variable selling expenses from the gross margin.
In concept, the contribution is the sales figure less actual out-of-pocket cost associated with producing what is sold. Assuming the product would not be made if it could not be sold, materials and much of the direct labor costs will be true out-of-pocket costs for most credit decisions. A certain proportion of overhead will also be variable, but clearly such items as depreciation and most salaries and other overhead expenses do not vary with a specific credit sale. If your sales representatives are on commission, part of the selling costs will be variable, although frequently most of these costs are fixed. Finally, it makes no sense to charge an average bad-debt allowance to a given credit decision.
For instance, a product whose standard costs total 90 percent of the selling price might have a variable production cost of 45 percent, miscellaneous variable overhead of 15 percent, and variable selling expenses of 10 percent. The remaining 20 percent is contribution to fixed overhead, research, advertising, depreciation, and similar items that are fixed in the situation under consideration. This 20 percent should be added to the 10 percent profit when the credit question is considered.
At the extreme, if a marginal credit risk requests credit to buy scrap of a type that cannot otherwise be sold, the contribution is almost 100 percent of the sales price. Ample credit, if required to move the goods, would be justified in that instance.
FINANCIAL MANAGEMENT: Estimating the return figure also requires an allowance for time and volume. Many new customers, if arrangements prove satisfactory to both parties, will become repeat buyers. It is therefore necessary to look at the total volume of business and at the total contribution the customer will make over time. Even with marginal customers, who may fail within a certain period, it is sometimes possible to do enough business and collect enough contribution to cover both the entire possible loss and earn a handsome profit as well.