Why is accounts receivable policy necessary?
Accounts receivable policy is mostly a marketing tool but the financial manager must ensure that its use maximizes profit and return on investment.
The financial manager has to ensure that accounts receivable policy is not used to the point it makes credit sales unprofitable.
A thorough analysis of costs and benefits of having a policy is the foundation for determining an appropriate accounts receivable policy.
The major costs are collection costs, delinquency costs and capital costs (funds for financing operations while awaiting payment for credit sales).
The benefits are the increased sales and profits.
The three most common accounts receivable policies are:
1. Cash policy
2. Net 30 policy and,
3. 2/10 Net 30 policy.
- Cash policy:
When a company chooses cash as its accounts receivable policy, the company extends no trade credit. The company therefore, has no collection costs and no capital costs;
Delinquent or default costs are non-existent and total cost of a cash accounts receivable policy is zero. In the absence of costs, what are the benefits/profits?
The total profits are calculated using the formula;
TR = S(M) – C)M) = A
TP = total profits under this policy,
S = the selling price per unit,
C = the cost of goods sold per unit,
M = the number of units sold under the cash policy,
A = the accounts receivable costs.
An example, if the selling price per unit is $15, cost of goods sold per unit is $10, the number of units sold under the cash policy is 150 and the accounts receivable costs are zero.
TP = $15(150) – $10(150) – 0
2. Net 30 policy:
A company incurs two types of accounts receivable immediately it extends 30-day trade credit. These are the cost of capital needed to finance the accounts receivable for 30 days and collection costs.
The cost of capital increases as the days the account remains uncollected increase. Of course, the company pays more interest on capital borrowed as long the account remains uncollected.
Increase in sales and profits is expected to offset increased collection costs. In determining the appropriateness of net 30 policy, the additional costs have to be weighed against the additional annual profits.
For example, if the number of units sold increased from 150 units (M) under the cash policy to 400 units under the net 30 policy, total revenue would have increased to:
S(N) =$20(400) – $8,000.
Total cost of goods sold would have increased to:
C(N) = $10(400) – $4,000.
Accounts receivable costs would be:
AR = (C(N))k + CC(N),
k = the cost of capital used to finance the accounts receivable,
C(N) = the value of the accounts receivable financed (cost of goods sold)
CC = the collection costs per unit,
CC(N) = the total collection costs
(C(N))k = the total capital costs.
Total revenue less total cost of goods sold and the total accounts receivable costs is the total profit. The total profit (TP) is given as;
TR = S(N) – C(N) – (C(N))k – CC(N).
If the cost of capital (k) is 10 percent and collection costs are $.20, the total profits (TR) from the net 30 policy can be calculated to be:
TP = $8,000 – $4,000 – (4,000).10 – .20(400)
The total profit from the net 30 policy is higher than from cash policy. At this point, the company would choose net 30 policy.
3. 2/10 Net 30 policy:
This policy gives the customer the choice of buying goods and rejecting the discount or buying goods and accepting the discount for early payment.
Customers who reject the discount would be the same as those under the net 30 policy. There is no incentive for them to buy more. In this case, the total profit would remain unchanged from $3,520.
The acceptance of the 2 percent early-payment discount would attract additional customers and increase in expected sales,
the additional revenue generated by offering the 2 percent discount is calculated thus;
Additional revenue = (1-d)S(Ni)
S = selling price per unit,
d = the 2 percent discount,
Ni = the additional number of units expected to be sold because of the 2 percent discount policy.
The additional cost of goods sold because of the 2 percent discount would be;
Additional cost of goods sold = C(Ni)
C = the cost of goods sold per unit as before,
Ni = the additional number of units expected to be sold because of the 2 percent discount.
The additional accounts receivable (AR) costs by the company because of the 2 percent discount would be:
Additional AR costs = (C(Ni)k/3) + CC(Ni).