Do you know that by extending goods and services to clients on credit can cause your organization dearly if not properly managed? Credit can kill or make your company and it is therefore important to manage it if your organization objective is to maximize on profits gained from sales.
Maximizing profitability being one of the key objectives of any business, it is important that all activities be geared towards achieving this objective. Failure to manage the cost of credit will work negatively in achieving profitability in an organization and can lead to collapse of otherwise profitable venture.
The reason behind extension of credit to customers is to maximize sales and in return earn more profits; failure to manage the receivables may result to bad debt and tied-up capital. Determining the cost of credit and factoring it in the price can help in profit maximization. The cost of credit is made up of three broad elements;
- 1. Bad Debt cost
Not all your credit sales will be paid for and you will find some clients not honoring their obligation due to various reasons, despite of your efforts to recover from them. This will call for a provision for bad debts and even a write-off. The best thing for a company to do is to ensure that vetting is done properly before extending credit to customers in order to minimize this cost. Don’t just extend credit to any client before evaluation of their capacity and ability.
- 2. Cost of Invested Fund
Most businesses run on borrowed funds to finance their operation which include extension of credit sales to customers. The funds don’t come without a cost and you are required to payback the loan with an interest. The interest on loan or overdraft must be considered when extending goods and services on credit and must be added to the price. Most companies don’t apportion interest incurred to their credit sales yet that is where most of the funds are tied-up. Opportunity cost is also incurred when all your monies are with the debtors, meaning that you cannot seize opportunities that may come your way due to lack of cash at hand. Debtors tie working capital which could be used to generate more profits if invested in other opportunities.
3. Administrative Cost
These include costs incurred in form of salaries, collection activities and any other expense by accounts receivables. The costs must be factored when determining the cost of credit in an organization; the activities may include telephone calls, demand letters, personal visits and time spent in pursuing debtors.
To realize profitability by any organization that sells on credit, good credit management must be in place; otherwise the company may suffer or even go under-receivership as a result of bad debts. Be proactive in managing your debtor’s book if you want to reap the benefits of increased sales, resulting from extending credit.