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The Credit Decision

You have taken the first three steps toward an effective credit operation. In other words, you have fixed your terms of sale; you have decided whether to sell on open account or to ask your customers to sign an IOU; and you have established a procedure for estimating the probability that each customer will pay up. Your next step is to decide on credit policy.

If there is no possibility of repeat orders, the credit decision is relatively simple. Figure 2.9 summarizes your choice. On the one hand, you can refuse credit and pass up the sale. In this case you make neither profit nor loss. The alternative is to offer credit. If you offer credit and the customer pays, you benefit by the profit margin on the sale. If the customer defaults, you lose the cost of the goods delivered.

The decision to offer credit depends on the probability of payment.You should grant credit if the expected profit from doing so is greater than the profit from refusing.

Suppose that the probability that the customer will pay up is p. If the customer does pay, you receive additional revenues (REV) and you deliver goods that you incurred costs to produce; your net gain is the present value of REV COST. Unfortunately, you can`t be certain that the customer will pay; there is a probability (1 p) of default. Default means you receive nothing but still incur the additional costs of the delivered

goods. The expected profit8 from the two sources of action is therefore as follows:

Refuse credit: 0 Grant credit: p _ PV(REV COST) (1 p) _ PV(COST)

You should grant credit if the expected profit from doing so is positive.

CREDIT DECISIONS WITH REPEAT ORDERS

What effect does the possibility of repeat orders have on your credit decision? One of the reasons for offering credit today is that you may get yourself a good, regular customer. Cast Iron has been asked to extend credit to a new customer. You can find little information on the firm and you believe that the probability of payment is no better than .8. If you grant credit, the expected profit on this order is

Expected profit on initial order = p Р РЈР Р· PV(REV COST) (1 p) Р РЈР Р· PV(COST) = (.8 Р РЈР Р· 200) (.2 Р РЈР Р· 1,000) = $40

You decide to refuse credit.

This is the correct decision if there is no chance of a repeat order. But now consider future periods. If the customer does pay up, there will be a reorder next year. Having paid once, the customer will seem less of a risk. For this reason, any repeat order is very profitable.

Think back to earlier material, and you will recognize that the credit decision bears many similarities to our earlier discussion of real options. By granting credit now, the firm retains the option to grant credit on an entire sequence of potentially profitable repeat sales. This option can be very valuable and can tilt the decision toward granting credit. Even a dubious prospect may warrant some initial credit if there is a chance that it will develop into a profitable steady customer.

Credit Decisions with Repeat Orders

To illustrate, let`s look at an extreme case. Suppose that if a customer pays up on the first sale, you can be sure you will have a regular and completely reliable customer. In this case, the value of such a customer is not the profit on one order but an entire stream of profits from repeat purchases. For example, suppose that the customer will make one purchase each year from Cast Iron. If the discount rate is 10 percent and the profit on each order is $200 a year, then the present value of an indefinite stream of business from a good customer is not $200 but $200/.10 = $2,000. There is a probability p that Cast Iron will secure a good customer with a value of $2,000. There is a probability of (1 p) that the customer will default, resulting in a loss of $1,000. So, once we recognize the benefits of securing a good and permanent customer, the expected profit from granting credit is

Expected profit = (p Р РЈР Р· 2,000) (1 p) Р РЈР Р· 1,000

This is positive for any probability of collection above .33. Thus the break-even probability falls from 5/6 to 1/3.

If one sale may lead to profitable repeat sales, the firm should be inclined to grant credit on the initial purchase.

CREDIT POLICY

Standards set to determine the amount and nature of credit to extend to customers.