Page 287 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 13.1.1 Costs

Costs associated are collection cost, capital cost, delinquency cost, and default cost. Costs
associated with extension of credit and accounts receivable:
1. Collection cost: These are administrative costs incurred in collecting the receivables from
the customers to whom credit sales are made. Included in the costs are (1) additional
expenses in the creation and maintenance of credit department with staff, accounting
records, stationery, postage and other related items, (2) expenses in acquiring credit
information either through outside specialist agencies or by the staff of the firm itself.
These expenses are incurred only if the firm does sell on credit. These costs are likely to be
semi-variable since up to a certain point, the existing staff will be able to carry on the
increased workload, but beyond that, additional staff will be required. Some costs are
variable, e.g., getting credit information from outside agencies in respect of new customers
added.
2. Capital cost: Accounts receivable is an investment in assets, and hence have to be financed
thereby involving a cost. The cost on the use of additional capital to support credit sales,
which alternatively could be profitably employed elsewhere is therefore a part of the cost
of extending credit or otherwise.
3. Delinquency cost: This arises when the customers fail to meet their obligations on due date
after the expiry of the credit period. Such costs are called delinquency costs. The important
components of this cost are: (1) blocking of funds for an extended period, (2) cost associated
with the steps to be initiated to the over dues, such as reminders and the collection efforts,
legal charges, where necessary etc.
4. Default cost: If the firm is not able to recover the over dues because of the inability of the
customers, such debts are treated as bad debts and have to be written off. Such costs are
known as default costs associated with credit sales and accounts receivable.

Did u know? With relaxation of credit standards, default expenses (i.e., bad debt expenses)
go up. If credit standards are made more restrictive, bad debt expenses go down.

13.1.2 Benefits

Benefits from credit sales and receivables management are increased sales and increased profits.
The impact of a liberal policy of trade credit is likely to have two forms. First, it is oriented to
sales expansion i.e., to increase sales to existing customers or attract new customers. Secondly,
the firm may extend credit to protect its current sales against emerging competition. Here the
motive is sales retention. As a result of increased sales, profitability also increases since the
firm’s fixed costs get distributed on a larger volume i.e., fixed cost per unit to be absorbed gets
reduced, increasing the profits of the firm.

13.1.3 Cost/Benefit Analysis

From the above discussion, it is clear that investments in receivables involve both benefits and
costs. The extension of trade credit has a major impact on sales, costs and profitability other
things being equal, a relatively liberal policy and therefore higher investments in receivable,
will produce larger sales. However, costs will be higher with liberal policies than with stringent
measures. Therefore, accounts receivable management should aim at trade off between profit
(benefit) and risk (cost). That is to say, decision to loosen funds to receivables (or the decision to
grant credit) will be based on a comparison of the benefits and costs involved. While determining

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