Accounting Best Practices, Fifth Edition

7–27. Modify the Credit Policy Based on Product Margins

Company management can cause significant losses if it attempts to loosen the corporate credit policy without a good knowledge of the margins it earns on its products. For example, if it only earns a 10 percent profit on a product that sells for $10 and extends credit for one unit on that product to a customer who defaults, it has just incurred a loss of $9 that will require the sale of nine more units to offset the loss. However, if the same product had a profit of 50 percent, it would require the sale of only one more unit to offset the loss on a bad debt. Thus, loosening or tightening the credit policy can have a dramatic impact on profits when product margins are low.

The obvious solution is to review product margins with management on a regular basis, whenever management wants to alter the credit policy, or when new products are about to be released. The concept can be taken a step further by altering the credit policy for each product family, so the credit limit is more closely aligned with product profit levels. This approach allows one to fine-tune credit policy to maximize profits. At its most advanced level, one can consider the credit policy in advance for products that are still in the design stage. If a company is using target costing to more precisely define product costs during the design stage, this can be an ...