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SOME GENERAL PRINCIPLES

Real-life situations are generally far more complex than our simple examples. Customers are not all good or all bad. Many pay late consistently; you get your money, but it costs more to collect and you lose a few months` interest. And estimating the probability that a customer will pay up is far from an exact science.

Like almost all financial decisions, credit allocation involves a strong dose of judgment. Our examples are intended as reminders of the issues involved rather than as cookbook formulas. Here are the basic things to remember.

1. Maximize profit. As credit manager your job is not to minimize the number of bad accounts; it is to maximize profits. You are faced with a trade-off. The best that can happen is that the customer pays promptly; the worst is default. In the one case the firm receives the full additional revenues from the sale less the additional costs; in the other it receives nothing and loses the costs. You must weigh the chances of these alternative outcomes. If the margin of profit is high, you are justified in a liberal credit policy; if it is low, you cannot afford many bad debts.

2. Concentrate on the dangerous accounts. You should not expend the same effort on analyzing all credit decisions. If an application is small or clear-cut, your decision should be largely routine; if it is large or doubtful, you may do better to move straight to a detailed credit appraisal. Most credit managers don`t make credit decisions on an order-by-order basis. Instead they set a credit limit for each customer. The sales representative is required to refer the order for approval only if the customer exceeds this limit.

3. Look beyond the immediate order. Sometimes it may be worth accepting a relatively poor risk as long as there is a likelihood that the customer will grow into a regular and reliable buyer. (This is why credit card companies are eager to sign up college students even though few students can point to an established credit history.) New businesses must be prepared to incur more bad debts than established businesses because they have not yet formed relationships with low-risk customers. This is part of the cost of building up a good customer list.